Financial History: Subprime Crisis Great Recession

A
Financial
History
of the
United States
From the
Subprime Crisis to
the Great Recession
(2006-2009)
(c) 2011 M.E. Sharpe, Inc. All Rights Reserved.

A
Financial
History
of the
United States
From the
Subprime Crisis to
the Great Recession
(2006-2009)
Jerry W. Markham
M.E.Sharpe
Armonk, New York
London, England

Copyright © 2011 by M.E. Sharpe, Inc.
All rights reserved. No part of this book may be reproduced in any form
without written permission from the publisher, M.E. Sharpe, Inc.,
80 Business Park Drive, Armonk, New York 10504.
Library of Congress Cataloging-in-Publication Data
Markham, Jerry W.
A financial history of the United States : from Enron-era scandals to the subprime crisis
(2004–2006) : from the subprime crisis to the Great Recession (2006–2009) / Jerry W. Markham.
v. ; cm.
Includes bibliographical references and index.
Contents: Enron and its aftermath—Other Enron era scandals—Corporate governance reforms—
Securities, banking, and insurance—Commodity markets—The rise of the hedge funds and private
equity—The mortgage market—A critical look at the reformers.
ISBN 978-0-7656-2431-4 (cloth : alk. paper)
1. Financial crises—United States—History—21st century. 2. Corporations—Corrupt
practices—United States—History—21st century. 3. Enron Corp—Corrupt practices—History.
4. Investment banking—United States—21st century. 5. United States—Economic policy—21st
century. I. Title.
HB3722.M375 2010
332.0973’090511—dc22 201000775
Printed in the United States of America
The paper used in this publication meets the minimum requirements of

American National Standard for Information Sciences
Permanence of Paper for Printed Library Materials,
ANSI Z 39.48-1984.
EB (c) 10 9 8 7 6 5 4 3 2 1

The thing that differentiates animals and man is money.
Gertrude Stein

Preface
This is the sixth volume of a financial history of the United States. The first
three volumes trace the development of finance in America from the colonial
period to the beginning of this century. They are entitled A Financial His-
tory of the United States: From Christopher Columbus to the Robber Barons
(1492–1900); A Financial History of the United States: From J.P. Morgan to the
Institutional Investor (1900–1970); A Financial History of the United States:
From the Age of Derivatives into the New Millennium (1970–2001). The fourth
volume describes the Enron-era financial scandals and other developments in
finance during the period 2001 to 2005 and is entitled A Financial History of
Modern U.S. Corporate Scandals: From Enron to Reform. The fifth volume
covers the aftermath of the Enron-era reforms and the developments in the
securities, derivative and mortgage markets that promoted subprime lending
and is entitled A Financial History of the United States: From Enron-Era
Scandals to the Subprime Crisis (2004–2006).
This volume describes the worldwide subprime crisis that occurred between
2007 and 2009. As a prelude to that crisis, this history examines the develop-
ment of the securitized mortgage products that came to be known as collater-
alized debt obligations (CDOs) and their attendant credit support in the form
of credit-default swaps (CDS) and monoline insurance. It next turns to the
factors that led up to the subprime crisis and then describes events during that
worldwide crisis as they unfolded, including the Great Panic that followed the
bankruptcy of Lehman Brothers. The massive government bailout programs
for financial services firms and automakers are addressed, and the regulatory
reforms enacted by President Barack Obama’s administration to prevent such
systemic failures in the future are considered.
xvii

Acknowledgments
The author thanks Beth Peiffer for her research assistance, her reading and
correcting the manuscript, and her diligence in preparing the bibliography and
index. George Sullivan and Rigers Giyshi, my research associates, provided
invaluable assistance in responding, always promptly, to my numerous and
persistent research requests. I am also, once again, grateful for the support of
the Florida International University College of Law.
xix

Introduction
Even while the government was in the midst of prosecuting executives in-
volved in the Enron-era scandals, another disaster was in the making in the
form of a residential real estate bubble. As housing prices soared, the practice
of “flipping” houses and condos for a quick profit became a popular Ameri-
can pastime. The real estate bubble was fueled, sometimes irresponsibly, by
liberal credit extensions at quite low “teaser” interest rates to “subprime”
borrowers. These borrowers had credit problems that disqualified them from
obtaining a conventional mortgage. Nevertheless, subprime loans were made
to individuals with poor or no credit histories on terms that assured they would
eventually default.
Fueling this subprime lending boom were mortgage brokers promoting
“no-doc” or “low-doc” loans that did not require the normal documentation
of the borrower’s creditworthiness. Credit quality was of no concern to the
mortgage brokers and lenders making those loans because the loans were
immediately resold by securitizing them in a pool, which was then sold to
investors as collateralized debt obligations (CDO). The CDOs often had
complex payment streams, and they were frequently insured against default
by “monoline” insurance companies with little capital or hedged by a new
financial instrument in the form of credit-default swaps. Those protections
allowed the “super-senior” tranches in subprime securitizations to obtain a
triple-A credit ratings from the leading rating agencies, making them highly
marketable in the United States and Europe. However, there was a major
hidden flaw in the ratings process. The rating agencies used risk models for
awarding the triple-A rating that did not take into account the possibility of a
major downturn in the real estate market.
Subprime mortgages were sometimes pooled to fund off-balance-sheet
commercial paper borrowings called “structured investment vehicles” (SIVs)
or “asset-backed commercial paper” (ABCP). Banks, such as Citigroup, used
short-term commercial paper borrowings to purchase mortgages held in their
SIVs. Those commercial paper borrowings funded the mortgages and provided
a profit through the spread between the higher rates paid by mortgages and the
lower rates then existing in the commercial paper market. These carry-trade
xxi

xxii introduction
programs had a flaw. In the event that commercial paper borrowers refused
to roll over their loans, SIVs would have to liquidate their mortgages. That
rollover might not be possible in a credit crunch or major market downturn.
Another danger was that short-term rates could rise faster than long-term rates,
erasing the spread or even inverting the payment stream.
The Fed funds rate (the interest rate for overnight funds among banks) was
6.50 percent in 2000 and fell to 1 percent in June 2003. This triggered a housing
mania in the United States. In order to burst the real estate bubble inflated by
those low rates, Alan Greenspan, the chairman of the Federal Reserve (the Fed),
set the first of a series of what eventually were seventeen consecutive interest
rate increases, beginning on June 30, 2004. Ben Bernanke, who succeeded him
in that post on February 1, 2006, put in place still more interest rate increases.
The effects of those actions were already becoming evident as Bernanke as-
sumed office. Indeed, the housing market experienced the largest decline in
new home sales in nine years in the month after Bernanke took office.
Undeterred by that rather ominous news, Bernanke imposed another rate
increase on March 28, 2006, pushing short-term rates to 4.75 percent, the
fifteenth straight interest rate increase. Bernanke suggested that more rate
increases would be forthcoming. The sixteenth straight rate increase followed
on May 10, 2006, pushing short-term rates to 5 percent, and the seventeenth
consecutive increase came on June 29, 2006, increasing short-term rates to
5.25 percent. The effect of this onslaught on the real estate market turned into
a financial crisis in 2007. Home sales and new residential construction slowed
dramatically, and the market became glutted with unsold homes.
Construction firms, such as Toll Brothers, cut back their building programs,
and the housing construction industry experienced its worst slump in forty
years. Speculators who had been earning unprecedented profits by buying
and quickly reselling properties, often after only a cosmetic touchup, found
that they could no longer flip their properties for a quick profit, so they were
left holding highly depreciated properties. “Short” sales, in which foreclosed
homes were sold for less than their outstanding mortgage, became common
as speculators defaulted, and as homeowners who did not have fixed-rate
mortgages could no longer meet their payments due to the rising interest rates.
Subprime homeowners, in many instances, simply walked away from their
homes and mortgages when the value of their home dropped below the amount
of the mortgage, a condition known as being “underwater.”
The growing crisis in the real estate market caused banks to tighten credit
requirements and to cut back on credit, creating a credit crunch in the summer
of 2007. In response to that concern, on August 17, 2007, the Fed issued a
statement encouraging banks to access its discount window more freely, but
the crisis only deepened. The Fed then cut interest rates by a surprisingly large
fifty basis points on September 18, 2007. That was the first rate cut in four
years. The size of it was surprising, nevertheless it had little effect in restoring
liquidity in the credit markets.

introduction xxiii
The Fed reduced rates by a further twenty-five basis points on October

31, 2007, pushing the Fed funds rate down to 4.5 percent. It warned that
this cut was likely the last because of inflation risks, which it then viewed as
equal to the risk of a recession stemming from the housing crisis. However,
this cut, too, had little effect, and failed to mitigate the continuing liquidity
crisis. The Fed responded with yet another twenty-five-basis-point cut on
December 11, 2007, which was disappointingly small and could not prop
up faltering market confidence. The Fed then broadened bank access to its
lending window in order to provide more liquidity in the system, but that
too had little effect.
Other problems abounded in financial markets. Traders in energy markets,
which were booming as crude oil prices increased to over $145 per barrel,
became the subject of attention as regulators and populist members of Congress
looked for a scapegoat for the high gas prices faced by consumers. In addi-
tion, foreclosures continued to mount and the number of defaults on subprime
mortgages skyrocketed. This caused a crisis in financial markets when SIVs
were unable to roll over their commercial paper. Large financial institutions,
including Citigroup, Merrill Lynch, Bear Stearns, and UBS, had to write off
billions of dollars in losses from SIVs and CDOs. Several of those institutions
fired their CEOs and sought capital to shore up their finances from a new, and,
to some, foreboding source:sovereign wealth funds of foreign governments. As
the crisis continued to spiral, some SIVs tried to sell their mortgage collateral,
but they could do so only at steep discounts. Concerned over losses from SIVs
and CDOs, banks cut back further on lending, worsening the credit crunch
that was causing funding problems throughout the economy.
Subprime problems spread to Canada, where a large number of ABCPs were
frozen and a rescue operation was mounted to protect banks that had exposure
from those vehicles. European investors had also become deeply involved
in the subprime market, and some financial institutions there faced massive
losses. Customers began a run on Northern Rock in England in September
2007, after they became worried about its mortgage exposure—the first bank
run in England in more than a hundred years. Depositors withdrew $2 billion
before the run was stopped by a $28 billion cash infusion from the Bank of
England. The British government later nationalized Northern Rock as well as
the Royal Bank of Scotland which was facing massive losses. The Bank of
England and the European Central Bank (ECB) also worked in tandem with
the Fed to make unlimited funds available to their banks for borrowing in
order to ease the credit crunch.
“Teaser” loan rates offered to subprime borrowers in the United States reset
at much higher rates and foreclosures skyrocketed. Though retired, Greenspan
voiced his support of the use of public funds to bail out those homeowners.
However, the administration of George W. Bush wanted the banks to simply
freeze existing rates on those mortgages. This touched off a debate over whether
individuals and institutions that made bad credit decisions should be bailed out

xxiv introduction
by the government or disciplined by the market. Those concerns were muted

as the subprime crisis worsened.
Citigroup and Merrill Lynch announced billions of dollars in losses from
subprime loans as 2007 ended, causing the removal of their CEOs and the
injection of billions of dollars obtained from sovereign wealth funds to shore
up their capital. Other financial institutions, including Morgan Stanley, also
announced billions of dollars in losses from subprime loans. Just as it seemed
that things could get no worse, a rogue trader, Jérôme Kerviel, a midlevel em-
ployee at France’s Société Générale, was discovered in early January 2008 to
have racked up $7.2 billion in trading losses on index futures contracts. The
bank liquidated Kerviel’s trades over the weekend of January 15 in the United
States. That liquidation was thought to have contributed to a worldwide selloff
in financial markets that, in turn, unsettled the Fed and led to a reduction in
Fed funds interest rate of seventy-five basis points.
Congress and the Bush administration panicked and quickly passed a $160
billion stimulus package, in the form of tax refunds of $1,200 for jointly
filing taxpayers and half that amount for single filers. The action had little
immediate effect. The Fed then had to arrange a dramatic takeover of Bear
Stearns by JPMorgan Chase in March 2008. Bear Stearns was brought down
by a liquidity crisis that arose after traders declined to roll over Bear Stearns’
positions in the money market. Assets of clients were pulled from the firm in
large amounts, and counterparties refused to trade with Bear Stearns because
of concern that it would fail, which it did. In order to close the deal, the Fed
agreed to guarantee some $30 billion in Bear Stearns assets. The Fed also threw
open its lending window to investment banks, as well as to the commercial
banks, and accepted as good collateral mortgage-backed securities, the very
instruments that led to the crisis.
Some other giants on Wall Street were forced to merge as a result of mas-
sive losses from subprime mortgage exposure. The venerable Merrill Lynch
was taken over by Bank of America. Wachovia Bank was folded into Wells
Fargo. JPMorgan Chase took over Washington Mutual, the largest savings
and loan association in the country. Still, the situation worsened, becoming a
full-scale panic, after Lehman Brothers failed in September 2008. A money
market fund then “broke the buck” (traded below the amount invested) and
touched off an investor run on money market funds, in which over $500 billion
was withdrawn before the government stepped in to guarantee the funds. The
giant insurance firm American International Group (AIG) had to be rescued
by the federal government at a cost of over $170 billion.
A $700 billion bailout package passed by Congress, called the Troubled
Asset Relief Program, (TARP), failed to halt the ensuing stock market panic.
The Treasury Department used TARP funds to inject capital into the largest
financial institutions, including $25 billion into Citigroup, but then paused.
That pause further destabilized an already volatile market. The value of Citi-
corp’s stock fell 60 percent in a single week, and the bank’s existence was

introduction xxv
threatened until the government stepped in to guarantee some $250 billion of

its mortgage holdings and to inject the bank with another $20 billion in capital.
General Motors and Chrysler were given funds for a bailout, and they were
later partly nationalized.
The Fed introduced various new lending programs in order to restart the
credit markets. The newly elected president, Barack Obama, stepped into the
crisis with an $838 billion stimulus package that he was able to persuade Con-
gress to pass just after his inauguration. The crisis was exacerbated, however,
when Chrysler was forced into bankruptcy in April 2009. General Motors met
the same fate shortly afterward and both were bailed out by the federal gov-
ernment. Still, some incipient signs of recovery (“green shoots” in the words
of Fed chairman Bernanke) were evident in the housing and credit markets
in mid-2009. It then appeared that the subprime crisis had actually bottomed
out in March 2009 but economic uncertainy remained late in 2010. Congress
and the still new administration began considering a near complete revamping
of the existing financial regulatory structure. That work was completed with
the passage of a 2,300 page bill called the Dodd-Frank Wall Street Reform
and Consumer Protection Act of 2010.that intruded the government deeply
into nearly every aspect of finance. Oddly, the legislation left untouched any
reform of the subprime lending by Fannie Mae and Freddie Mac, who were
at the center of the crisis.
This book describes these events and attempts to address the flaws in the
financial system that gave rise to the subprime crisis. It also considers the
various “reform” proposals that are being floated in response to this crisis.

III
The Growth of the Mortgage Market

9. Securitization
Government-Sponsored Enterprises
GSEs
About 43 percent of Americans owned their own homes in 1940. That number
rose to 64 percent in 1968. Gains thereafter were incremental, rising to 69 per-
cent in 2004 and falling back to 68 percent in 2007. Between 1968 and 1996,
the value of home mortgages outstanding rose from $264 billion to $3.7 trillion.
A lot of that growth was the result of activities by the government-sponsored
enterprises (GSEs) for the mortgage market: the Federal Home Loan Mortgage
Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie
Mae), and the Government National Mortgage Association (GNMA, or Ginnie
Mae). Freddie Mac was initially supervised by the Federal Home Loan Bank
Board (FHLBB), and its stock was held by the banks in that system. However,
Freddie Mac was privatized and became a public company in 1989, and its
stock was listed on the New York Stock Exchange (NYSE).
Fannie Mae was privatized even earlier, in 1968, and it was listed on NYSE.
However, both Freddie Mac and Fannie Mae remained GSEs. The president
appointed five of the eighteen directors of each of these GSEs, and they were
allowed to issue their securities through the Federal Reserve’s electronic book
entry system. Both Fannie Mae and Freddie Mac had access to a line of credit
from the federal government, and both were exempted from state taxes, except
real estate taxes. They were also exempted from the registration requirements
of the federal securities laws, but the Treasury Department was required to
approve their borrowings.
Another group of GSEs, the Farm Credit System lenders, sustained large
losses during the 1980s. The federal government then intervened to relieve
the farming crisis that caused those losses by providing backup support to
the Farm Credit System. This bailout was justified on the theory that they
were “too big to fail,” a theory that would be widely applied during the sub-
prime crisis. Other GSEs were also affected by that crisis. Fannie Mae had
been borrowing at short-term interest rates to fund its long-term fixed rate
377

378 The Growth of the Mortgage Market
mortgage obligations, which worked well as long as short-term rates did not
increase. Fannie Mae was quite profitable until the S&L crisis in the 1980s,
when short-term interest rates did increase, causing Fannie Mae to reach a
point of a negative net worth of a $10.8 billion, which was reversed when
interest rates began to fall.
Congress became concerned over the financial stability of Fannie Mae and
Freddie Mac during the savings and loan (S&L) crisis. It directed the Trea-
sury Department and the Government Accountability Office (GAO) to make
an evaluation of the financial condition of those two GSEs. They found that
Fannie and Freddie had grown rapidly in the 1980s and concluded that these
GSE’s posed systemic risk that could not be avoided through diversification
or market discipline. The Treasury Department recommended that strong
regulatory supervision be imposed over these entities. If that were not pos-
sible, the department believed that Congress should cut all governmental ties
with these entities.
After considering those reports, Congress passed the Federal Housing
Enterprises Financial Safety and Soundness Act of 1992. That legislation
added additional regulation over Fannie Mae and Freddie Mac. Their regu-
lation was assigned to the Office of Federal Housing Enterprise Oversight
(OFHEO), an independent entity within the Department of Housing and
Urban Development (HUD). OFHEO was headed by a director who was
appointed by the president for a five-year term. The government was also
given authority to appoint a conservator for the GSEs should they become
dangerously undercapitalized, a event that occurred during the subprime
crisis. This was the same sort of power given to the bank regulators for the
resolution of failed banks.
OFHEO was directed by its authorizing legislation to stress test the
portfolios of the GSEs and set risk-based capital requirements based on
a ten-year scenario of an economic downturn in the housing and financial
markets. The GSEs were to be stress tested by shocking both interest rates
and default rates at the same time, and severely, in order to measure possible
risk exposures. Credit loss assumptions were based on the region with the
highest default rate, historically defaults were uneven across the country,
and that loss assumption was carried out over the ten-year test period. The
stress test–based capital requirement went into effect in 2002. Fannie Mae
was then required to have capital of $21.4 billion, while it claimed capital
of $27.3 billion.
The 1992 legislation stated that the government did not guarantee the debt
of Fannie Mae and Freddie Mac. However, the market continued to value
the debt securities that they issued and their guarantees as having an implied
guarantee from the federal government. That assessment proved correct dur-
ing the subprime crisis, which had an advantage for consumers. The implicit
guarantee effectively subsidized loans for homeowners through lower interest
payments and reduced down payments.

Securitization 379
Securitization
The GSEs became a central part of the residential mortgage market as the result
of their securitization programs. The securitization concept is not a new one.
The process essentially involves the sale of a future stream of payments, or
some other asset, whose value will be realized in the future. An early example
of securitization was found in Amsterdam in the seventeenth century. There, a
corps of women recruited sailors for the Dutch East India Company by luring
them off the streets with promises of food, shelter, drink, and sex. The women
were paid a portion of the future wages of their recruits. The right to receive
those payments was guaranteed by a marketable security called a transport-
brief issued by the company. Those securities were purchased by zielkoopers
(buyers of souls) at a discount that reflected the high death rate of the sailors.
By pooling the securities, the zielkoopers were able to diversify their risks.
However, a rising mortality rate among sailors bankrupted many of these
merchants. Subprime lenders had a similar experience in this century.
This concept of selling the right to a future payment was applied to mort-
gages by the GSEs. They created a secondary market for mortgages by placing
them in a pool. Interests in the pool were sold to investors, who thereafter re-
ceived the principal and interest payments from the mortgages. The mortgages
placed in the pools were initially required to all be of the same type, such as a
single-family house, and the interest rates on those mortgages were all the same.
To further streamline this process, the terms of mortgages being pooled were
standardized so that their payment streams could be valued uniformly. Fannie
Mae and Freddie Mac spearheaded the effort to create uniform documentation
after the passage of the Emergency Home Finance Act of 1970.1
Ginnie Mae pioneered the sale of these pooled mortgages in the form of
“pass-through certificates” that gave an investor a pro-rated portion of the
principal and interest payments received from mortgages placed in the pool.
This process allowed lenders to originate loans, to sell the loans through Ginnie
Mae, and then to use the proceeds of that sale to originate more loans. This
process increased the amount of credit available to homeowners and helped
lower interest rates. Ginnie Mae issued its first mortgage-backed security
in 1970. Since then, it has guaranteed over $2 trillion in mortgage-backed
securities.
The interest rate paid on Ginnie Mae pass-through certificates was slightly
less than that on the underlying mortgages, the difference being used to pay
servicing and guarantee fees. The service fees were usually paid to the issuing
institution, which was responsible for collecting mortgage loan payments and
passing the principal and interest through two certificate holders. Ginnie Mae
charged issuers a guarantee fee, which was typically six basis points for securi-
ties backed by loans for single-family residences, the majority of its business.
Notwithstanding those fees, the yield on Ginnie Mae pass-through certificates
was usually higher than that on other government-guaranteed securities with

comparable maturities, such as Treasury bonds. The Ginnie Mae guarantee

greatly enhanced the marketability of these pass-through securities.
Ginnie Mae mortgages have generally been untroubled. In November 2002,
however, executives at First Beneficial Mortgage Corporation were convicted
of engaging in fraudulent practices in connection with Ginnie Mae pools. The
defendants used forged documents to create pools that were collateralized with
nonexistent properties and that were not insured by a federal agency, as was
required by Ginnie Mae’s rules. Ginnie Mae suffered a loss of $20 million
as a result of that fraud. There was also a signal in this market that subprime
residences posed risks. Many low-cost pre-fabricated homes were repossessed
between 2000 after 2002, after a downturn in the economy.
The certificates guaranteed by Ginnie Mae were called “pass-through” be-
cause they simply passed the monthly mortgage payments on the mortgages
held in the pool on to the certificate holders. This meant that the certificate
holder received monthly interest payments plus an amortized portion of the
principal on the mortgage. During the initial stages, the principal payments
were only a small portion of the monthly payment but, as the principal on the
mortgage shrank over time, the portion of the payment attributable to principal
grew each month. This payment stream raised some complex yield issues and
reinvestment concerns.
Many mortgages are paid off before maturity because as their income grows
homeowners move or purchase a more expensive home. Many homeowners
also refinance their mortgages when interest rates drop. This results in a return
of principal on that mortgage, which is then passed through to the holders
of Ginnie Mae certificates. The holder of the certificate then had to reinvest
those funds. If interest rates had fallen since the purchase of the pass-through
certificate, that reinvestment would have to be made at the then-existing lower
interest rate, which displeased the certificate holder. This created a reinvest-
ment risk.
In order to allow investors to make a more informed investment decision,
the issuer of mortgage-backed securities modeled the expected rate of repay-
ment based on past experience. This gave the pass-through certificate holder a
general idea of what to expect in terms of repayment. However, those models
were not always accurate, as when unusual interest rate changes occurred that
might accelerate or slow home sales and refinancing. This created a “repay-
ment” risk that funds from the mortgages would be paid back more quickly
or more slowly than predicted by the models.
Because of this repayment feature, pass-through securities did not react in
the same manner as corporate bond prices when interest rates fell. Bond prices
generally increase when interest rates fall because the holder is now receiving
a higher interest rate than is available in the market. In contrast, pass-through
certificates may not increase at the same rate because there will be a greater
prepayment of principal from accelerated refinancing that must be reinvested
at lower market rates.

Securitization 381
Collateralized Mortgage Obligations
Freddie Mac sought to address the investment concerns associated with the
pass-through securities developed by Ginnie Mae. Initially, Freddie Mac sold
something called Freddie Mac MCs, or “motorcycles,” as they were nicknamed,
which guaranteed the timing of the cash flow from the certificates, as well
as the principal and interest. However, that simply shifted the risk to Freddie
Mac. In order to avoid that result, Freddie Mac began offering “collateralized
mortgage obligations” (CMOs), also known as “real estate mortgage invest-
ment conduits” (REMICs). CMOs were a product created for Freddie Mac, in
1983, by Larry Fink, who was then working at First Boston. Fink later headed
BlackRock, the giant asset manager, and played a prominent role in managing
distressed pooled mortgage assets during the subprime crisis.
CMOs divided principal and interest payments from the mortgages placed
in the pool into different payment streams. Unlike investors in pass-through
securities, CMO investors did not have pro-rated principal and interest pay-
ments passed through to them. Instead, the CMO mortgage payments were
divided into separate tranches with varying payment streams and with differ-
ing maturities, seniority, subordination, or other characteristics. This allowed
investors to choose between investments with a longer-term investment and
with a shorter term. The long-term investor was given some protection from
prepayment risks by a requirement that principal repayments first be directed
to the short-term investors. Only after they were completely paid off would
the longer-term tranches start receiving principal payments.
The CMO concept was designed to guard against prepayment risk. How-
ever, investors lost sight of a different risk posed by such securities. There is
an “extension” risk, which is the opposite of the prepayment risk. Extension
risk occurs in the event of an unusual increase in interest rates. In such a case,
homeowners will be reluctant to sell their homes or to refinance them because
they will have to pay a higher interest rate on a new mortgage. This means
that the certificate holder will be locked in for a longer than predicted period
of time, which will cause a drop in the value of the certificate because the
certificate holder will be receiving a lower rate than the one prevailing in the
market for a longer than predicted time.
CMOs often contained exotic tranches, including inverse floaters and in-
verse interest-only strips that converted fixed-rate mortgages into floating-rate
tranches.2 Inverse floaters had a set principal amount and earned interest at a rate
that moved inversely to a specified floating index rate. The principal amount
on which that interest rate was calculated was determined by reference to the
outstanding principal amount of another tranche. As the reference tranche was
paid off, the principal on which the inverse interest-only strip earned interest
decreased. A rate increase reduced the inverse interest-only floating rate but
also extended its maturity and, thereby, increased total interest payments. These
tranches were deemed necessary in order to cover the effects of increases in

interest rates, which caused their maturity date to lengthen. Inverse floaters
could receive high returns if interest rates declined or remained constant but
suffer large losses if interest rates decreased. Inverse interest-only strips did not
receive principal payments. These floaters were leveraged, so a small increase
in interest rates would cause a dramatic decrease in the inverse floating rate.
Inverse floaters and inverse interest-only strips were popular after they were
introduced in 1986 and 1987, during a period of decreasing or stable interest
rates. That situation changed on February 4, 1994, when the Federal Reserve
(the Fed) increased short-term interest rates for the first time in five years.
The Fed then embarked on a series of rate increases that had some disastrous
effects on the bond markets. CMOs were crushed by these increases because
they virtually stopped mortgage repayments, extending the average maturity
of CMOs, and hammering their inverse-floater tranches. As a result, the market
in CMOs collapsed and large losses were suffered.
A valuation problem surfaced during the collapse of the CMO market. Some
of the CMO tranches were so complex that Goldman Sachs had to use multiple
supercomputers to run simulations of cash flows under different interest-rate
scenarios. That problem presaged the valuation issues that emerged during the
subprime crisis in 2007. Among those hurt by the CMO market was Merrill
Lynch, after one of its traders, Howard Rubin, lost over $370 million, in 1987,
through unauthorized CMO transactions. Rubin was fired by Merrill Lynch
and was quickly hired by Bear Stearns, where he became a star in its mort-
gage trading department. JPMorgan lost $50 million from CMO investments
in 1992. This was only a temporary setback. Mortgage-backed securities
guaranteed by GSEs increased in value from $200 million in the 1980s to $2
trillion in 2007.
Mortgage Market Growth
Secondary Market
The secondary market involved sales of mortgages after they are originated.
This market brought in investors who purchased the loans either directly or in-
directly from their originators. The investors purchasing these mortgages might
hold them on their own books or they could be pooled and sold to investors in
bond-sized units. By 2005, almost 60 percent of home mortgages originated in
that year were securitized in such a manner. The secondary mortgage market
had essentially two tiers, securitized offerings that had a government or GSE
guarantee and private offerings that did not have such a guarantee.
Borrowers taking out mortgages that were not guaranteed by a GSE were
usually required to purchase expensive private mortgage insurance when
their loan-to-value ratio exceeded 80 percent, that is, when the borrower’s
down payment was less than 20 percent of the purchase price of the home.
That mortgage insurance usually covered 20 to 30 percent of the mortgage

Securitization 383
balance. In contrast, borrowers insured by the Federal Housing Administra-

tion (FHA) could make very low down payments (as low as 3 percent) and
usually pay interest rates competitive with prime mortgages because of the
FHA guarantee. FHA borrowers could also finance their mortgage insurance
premiums and some closing costs.
The FHA backed its mortgage insurance program through its Mutual
Mortgage Insurance Fund, which was funded by the insurance premiums
paid by borrowers. As a result of losses from mortgages that went bad in the
1980s, Congress increased the premiums payable by homeowners receiving
FHA insurance. The amount of those premiums was set at 1.5 percent of the
mortgage balance upon origination of the mortgage and annual premiums of
0.5 percent. Congress also set limits on the size of FHA-guaranteed loans.
Those limits were based on local median house prices in 2007, which varied
from about $200,000 to $360,000. Those loan limits would rise during the
subprime market when lending for higher-value homes froze.
Congress sought to enhance the attractiveness of mortgage-backed securities
to investors through passage of the Secondary Mortgage Market Enhancement
Act of 1984, which exempted such securities from Fed margin requirements
and allowed banks and fiduciary investors to invest in these obligations. They
proved to be popular investments. By 1986, GSEs were able to buy or guar-
antee more than $1 trillion in residential real estate loans, much of which was
securitized. By 1990, Fannie Mae had $103 billion in assets and had issued
$300 billion in mortgage-backed securities. Freddie Mac had $41 billion in
assets and had issued $316 billion in mortgage-backed securities.
In 1988, Congress created another GSE, the Federal Agricultural Mortgage
Corporation (Farmer Mac), tasked with creating a secondary market for ag-
ricultural loans. Farmer Mac was authorized to guarantee mortgage-backed
securities issued by private lenders and pools of agricultural mortgages. Com-
mercial rural lenders and other private bodies that utilized its services owned
Farmer Mac. Its board of directors had fifteen members, five of whom are
appointed by the president.
The Federal Home Loan Banks (FHLBs) also created programs, first au-
thorized 1998, in which they purchased pools of conventional and federally
insured mortgage loans from member banks. They purchased $12.7 billion
in FHA and Veterans Administration (VA) loans in 2000, taking a significant
portion of Ginnie Mae’s market share. Ginnie Mae’s overall market share of
mortgage-backed securities dropped from 42 percent in 1985 to 7 percent
in 2004. However, it still retained a large market share of FHA-insured and
VA-guaranteed loans.
The result of these programs was that the government had become the larg-
est financial intermediary in credit markets. The size of these programs began
to raise concerns. Critics wanted user fees to cover the cost of government-
sponsored loans. Concerns were also raised that mortgages held by GSEs
and their guarantees were a liability that could become massive in the event

of a collapse of the residential mortgage market. Critics wanted the federal

government to sell off existing loan assets and include all federal loans in the
government’s budget.3 They were ignored.
Private Securitizations
Commercial banks entered the mortgage-backed securities market. They were

at somewhat of a disadvantage because they did not have the implicit govern-
ment guarantee of Fannie Mae and Freddie Mac or the explicit guarantee of
Ginnie Mae. In order to address investor concerns, private banks enhanced their
private pools through credit support arrangements such as by overcollateral-
izing the pool. Some banks also provided letters of credit that would support
the pool up to a specified percentage of loss, say, 10 percent. The high rate of
return on these assets attracted investors and allowed these securitizations to
be marketed without recourse to the bank that pooled the assets.
As was the case for CMOs, these instruments could be structured to provide
flexibility for investors in the type of payment stream that they would receive.
In the event of defaults, the pool of assets being securitized were bankruptcy-
remote from the issuer, which meant that general creditors of the issuing bank
could not make claims on the assets. Another advantage was that it allowed the
issuer to “monetize” assets in advance of their own self-liquidation as well as
allowed the assets to be taken off the issuer’s balance sheet. Of course, such
off-balance-sheet structures could be abused, as occurred at Enron.
The FHA competed with private mortgage lenders in loan origination. The
latter could provide mortgage products with flexible payment and interest op-
tions. Because of that competition, and FHA product restrictions, the market
share of home mortgages insured by the FHA fell from 19 percent in 1996
to 6 percent in 2005. The use of these non-GSE mortgage-backed securities
grew rapidly, even though they did not contain an explicit or implicit govern-
ment guarantee against default. It was estimated that more than $2 trillion in
mortgages was securitized. The market share of private-label mortgage-backed
securities doubled between 2003 in 2005, reaching 29 percent of all outstand-
ing mortgage-backed securities in the latter year.
Alarmingly, two-thirds of the privately issued mortgage-backed securities
were for nonprime mortgage loans in 2006, compared with 46 percent in 2003.
As the Federal Deposit Insurance Corporation (FDIC) noted in 2006: “[I]n-
vestors appear willing to assume greater risk in their search for the yield.”4
This was a dangerous phenomenon in the banking business. As Robert Rubin,
a leader at Citigroup during its subprime difficulties, concluded while he was
secretary of the treasury under the Clinton administration, the prevailing
mentality of investors is to downplay or ignore risks in order to “reach for
yield.”5 Securitization could be abused in other ways. Patrick D. Quinlan, Sr.,
pleaded guilty to charges that his company, MCA Financial, misrepresented
the risk and returns from $71 million in securitized mortgage loan pools that it

Securitization 385
sold between 1994 and 1999. Investors lost some $50 million in that scheme.
Quinlan was sentenced to ten years in prison.
Mortgage scoring and automated underwriting systems for mortgage loans
aided private lenders. These underwriting systems used algorithms called a
“scorecard” that measured the risk of default. The scorecard analyzed data
relating to the borrowers’ credit history and credit scores, as well as their cash
reserves and credit requirements, in order to predict the likelihood of a default.
FHA lenders used their own scorecard. If that scoring system indicated that
the loan application should be rejected, the application would be reviewed
manually before a final rejection decision was made. This system worked well
until its requirements and scoring methodology were abandoned for subprime
loans that did not meet its criteria.
Asset-Backed Commercial Paper
The securitization concept spread to other instruments. Commercial banks

began securitizing consumer automobile loans in 1985. In the following year,
credit card receivables were used to securitize commercial paper. These asset-
backed commercial paper (ABCP) programs spread to other assets, including
consumer loans, leases, trade receivables, and, later, subprime mortgages.6
The ABCP programs used a special-purpose vehicle (SPV) to buy the credit
card receivable or other income-generating asset from the sponsoring bank or
financial institution—which removed that asset from the balance sheet. SPVs
sold commercial paper in order to buy those assets. The assets in the SPV
pool, in turn, secured that commercial paper. SPVs were an off-balance-sheet
instrument that was not subject to the more restrictive Basel II bank regula-
tory capital requirements used for on-balance-sheet instruments. These off-
balance-sheet instruments joined the “shadow banking” created by nonbanks
through CDOs.
These securitization devices also included “structured investment vehicles”
(SIVs, or perhaps, as some wags suggested during the subprime crisis, “sieves”).
SIVs were ABCP programs used by Citigroup, starting in 1988, to arbitrage
short- and long-term interest rates by acquiring highly rated, medium- and
long-term fixed income assets and placing them in an SPV. Those purchases
were funded with short-term highly rated commercial paper and medium-term
notes. These structures were initially given high ratings by credit agencies.
However, those ratings were cut sharply during the subprime crisis, making
these securities illiquid and slashing their value. These instruments caused
large losses for Citigroup in particular.
As Citigroup discovered, such an arrangement entailed a serious risk. Com-
mercial paper is a short-term instrument, while the assets in an ABCP pool
that funded the commercial paper were longer term. This mismatch required
the commercial paper issued by the pool to be continually rolled over until
the pool self-liquidated as mortgages were paid off or, in the case of SIVs,

refunded with additional long- or medium-term assets. In the event of a crisis

in the money markets, however, such a rollover might not be possible. In that
case, the issuer would be faced with the problem of selling the assets, which
might be illiquid or sold at fire-sale prices. To guard against such an event,
banks provided a loan facility to pay off the commercial paper holders. This left
the bank holding the bag should the assets decline in value below the amount
extended under that credit facility or in excess of any credit protection.
ABCPs provided advantages to issuers, including access to funds at interest
rates lower than that charged by commercial banks. ABCP programs became
popular because the commercial paper market was usually quite liquid, and
issuers had a great deal of flexibility in the timing and duration of their offerings
in that market. Those offerings were also exempt from registration requirements
of the Securities and Exchange Commission (SEC). The commercial paper
market grew from $1.5 trillion in 2005 to $2.25 trillion in August 2007. The
ABCP market comprised about $1.2 trillion of that amount at the time of the
credit crunch, a market that shrank to a little over $800 million by December
2007 when many programs were frozen and caused massive losses.
Student Loans
Securitization spread beyond commercial banks. One popular securitization

payment stream involved the government-guaranteed student loan program
that flowed from the policies expressed in the National Defense Education Act
of 1958. That legislation was passed in response to concerns that, as a result
of the Sputnik satellite launch by the Soviet Union in 1957, the United States
was falling behind in mathematics education and science. Congress decreed
in that legislation that the national defense required loans and fellowships
that would encourage students to study science and technology. That program
proved popular and drew demands for expansion into other fields of study.
The student loan program that began in 1965 broadened the government’s
encouragement of education to all other postsecondary education programs.
That program guaranteed private loans to undergraduate students up to specific
amounts annually and with a cumulative limit. It provided those students with
a large interest rate subsidy that paid lenders an amount sufficient to guarantee
a rate of return of 3.5 percent above the yield on ninety-day Treasury bills. The
government also paid all interest costs during the period that the student was
enrolled in college. Students did not have to begin repayment until six months
after graduation and had from five to ten years to pay off the loan.
In 1983, some 3 million students received government-guaranteed loans,
about 30 percent of all students in postsecondary educational schools. These
subsidized loan programs also increased college enrollment. The student loan
subsidies were justified on grounds that the government would recover their
cost from higher tax payments, which would be paid by better-educated citi-
zens with higher-paying jobs than those without such education. However, as

Securitization 387
the Chicago economist Milton Friedman noted, the prediction of a particular

rate of return on such an investment was most uncertain and subject to much
variation. Critics also charged that the program encouraged unqualified indi-
viduals to enter postsecondary education programs. Many student borrowers
were unable to complete their degrees and were left saddled with large debts
that they had difficulty paying off because they were qualified only for low-
paying jobs.
In the event, as in the mortgage market, private lenders needed a secondary
market where they could sell the loans that they originated. To that end, the
Student Loan Marketing Association (Sallie Mae) was created in 1972, as a
federally chartered, stockholder-owned corporation, charged with creating a
secondary market in student loans. Like Fannie Mae and Freddie Mac, the
president of the United States was entitled to appoint a portion of its board
of directors. Those appointments tended to be driven by politics rather than
financial acumen. As a GSE, Sallie Mae was exempt from state and local
taxes, other than real estate taxes. As with Fannie Mae and Freddie Mac, its
debt offerings were exempt from SEC registration requirements. Sallie Mae
was also given access to the Federal Financing Bank, which could provide it
with low-interest rate borrowings. However, Sallie Mae used that facility only
once, when it borrowed seed money to commence operations.
In addition to purchasing student loans from originating banks, and, like
Ginnie Mae, Fannie Mae, and Freddie Mac, securitizing them, Sallie Mae also
originated loans of its own. The securitization generated fees, but it initially
provided another monetary advantage to Sallie Mae. The Omnibus Budget Rec-
onciliation Act of 1993 required Sallie Mae to pay a 0.3 percent “offset fee” to
the Department of Education (DOE), created in 1980, on the principal amount
of each student loan held on Sallie Mae’s books. However, an appeals court
held in 1997 that the fee did not apply to loans securitized by Sallie Mae.
Government aid to students expanded with the creation of the DOE, which
provided more than $65 billion in student loans in 2005. DOE programs in-
cluded Pell grants, Stafford loans, PLUS loans, Federal Work-Study program
funding, and Perkins loans. Government-guaranteed student loans were insured
by the Student Loan Insurance Fund (SLIF), which protected borrowers in
the event of a default on a guaranteed loan. SLIF was supported by insurance
premiums paid by borrowers and supplemented by congressional appropria-
tions when there was a shortfall. To better assure repayment, student loans
were not dischargeable in bankruptcy, except upon a special showing of undue
hardship.
The private student loan market, which was nearly nonexistent in the 1990s,
had grown to $17 billion by 2006. In contrast, the federally guaranteed student
loan market was almost $60 billion in 2006. Because privately issued student
loans were not guaranteed by the federal government, they charged higher
interest rates, sometimes as much as three percentage points more than feder-
ally guaranteed loans.

Sallie Mae’s founding legislation required it to become a private company

by 2008, taking it down the same path as Fannie Mae and Freddie Mac. Sallie
Mae began privatizing its operations in 1997 and became a fully private entity
in December 2004, severing all ties to the federal government. It then began
operating as SLM Corporation. No small entity, it had some 10 million student
loans outstanding when it was privatized. After privatization, Sallie Mae’s
loan programs consisted primarily of originating and holding student loans
through its participation in the Federal Family Education Loan Program and
its own non-federally guaranteed private education loan programs. Sallie
Mae marketed its loans through on-campus financial aid offices and direct
marketing.
The student loan market was roiled in 2007 by scandals involving improper
incentives being given by lenders, including Sallie Mae, to college financial
aid officers. Those incentives were inducements for promoting the lender’s
business to students by listing the lender at the top of their preferred lender
lists. Some aid officials were paid to sit on lender advisory committees, and
lenders, in turn, were allowed to answer telephones at the university financial
aid centers. The University of Texas rated student lenders on the amount of
“treats” that they provided to loan officials at the university. The university
fired the director of financial aid at its Austin campus for recommending Stu-
dent Loan Xpress to students, after he bought stock in its parent company, CIT
Group, a commercial lender that was later devastated by the subprime crisis.
Financial aid officers at Johns Hopkins University and two other prominent
schools received $160,000 in gratuities from Student Loan Xpress. Three
managers at Student Loan Xpress were suspended for making such payments.
Several college financial aid officials were fired at other schools.
In May 2007 Congress reacted to these scandals with the Student Loan
Sunshine Act, which banned gifts and regulated student loan marketing efforts
by lenders. New York attorney general Andrew Cuomo began an investigation
of these practices, discovering that a number of schools had “revenue-sharing”
agreements with student lenders, pursuant to which the lenders paid the schools
a percentage of the loans generated at the school. Cuomo found that student
loan companies had provided all-expense-paid trips, entertainment, and other
perks to financial aid officials, in exchange for being placed on their preferred
lender lists. Lenders on those preferred lender lists typically received up to 90
percent of the loans generated by the school.
Sallie Mae was one of the targets of the Cuomo probe. It agreed in April 2007
to stop making payments to school officials as an incentive for recommending
its loans and paid $2 million to settle charges over that conduct. Sallie Mae
also agreed to adhere to a code of conduct created by Cuomo, which became
a favorite tool in his investigations of financial services firms. David Charlow,
the financial aid director for Columbia University’s undergraduate college
and engineering school, was fired after it was discovered that he had received
$100,000 in profits from stock of a company that owned Student Loan Xpress

Securitization 389
before it was acquired by the CIT Group. Charlow had placed Student Loan
Xpress on Columbia’s preferred lender list. The university agreed to pay $1.1
million to a Cuomo-created fund to educate students about loans. Columbia
further agreed to have its financial aid office monitored by state officials for
five years. It was unclear what the legal basis was for this intrusion of govern-
ment into private business.
Student loan provider Education Finance was another target of Cuomo’s
because of its practice of paying kickbacks to schools that promoted its loans
to their students. A group of financial aid officers agreed to a ban on the receipt
of gratuities from lenders, and lenders agreed to be monitored by Cuomo,
thereby creating his own special student loan regulatory organization. Goal
Financial, which had been using mailings that looked like they had come from
the federal government to solicit loans, entered into a settlement with Cuomo.
The firm also offered iPods, gift cards, and other goodies in order to attract
student borrowers. It agreed to adopt the Cuomo code of conduct and to pay
$350,000 into a financial aid education fund established by Cuomo.
Seven student loan companies agreed to change their marketing practices in
a settlement with Cuomo in September 2008, and they, as well as twenty-six
schools that had student loan programs, agreed to adopt his code of ethics,
which was later included in legislation in New York. Cuomo was more low-
key than his predecessor as attorney general, Eliot Spitzer, but blasted the
DOE for not discovering and stopping these student-lending practices. Cuomo
also began an investigation of universities, including Columbia, Cornell,
and Georgetown, to determine whether they were improperly receiving any
benefits from their relationships with companies providing health insurance
for students.
Lenders had benefited greatly from government subsidies under the Federal
Family Education Loan (FFEL) program that provided federal subsidies and
performance guarantees for privately issued student loans. However, the pas-
sage of the College Cost Reduction and Access Act of 2007 reduced interest
rates that student borrowers paid on their loans, creating a further subsidy for
those students (rather than the lenders), valued at $7 billion over the subse-
quent five years. The legislation also reduced yields on student loans, making
student loans unprofitable for the banks. Within a few months, more than
one-third of the larger banks in this market suspended further student loan
activities. Among the lenders terminating participation in the program was the
Brazos Higher Education Service Corporation, which had some $15 billion
in student loans outstanding. Bank of America stopped making loans in the
private student loan market. The Pennsylvania Higher Education Assistance
Agency, one of the largest student lenders, also exited the market in federally
guaranteed student loans.
By April 2008, forty-six lenders, including NorthStar Education and CIT
Group, had stopped making student loans. Another problem was that student
loan default rates were approaching 7 percent in 2007, compared with 4.6

percent in 2005. Hard-hit by this upsurge in defaults and reduced lending was
Education Resources Institute, a firm that was ensuring more than $17 billion
in private student loans but declared bankruptcy on April 7, 2008. Several
colleges tried to fill the gap left by the private lenders that had quit the student
loan market by having their students obtain direct loans from the federal gov-
ernment. Some of the better-endowed colleges provided free tuition in various
forms, but the subprime crisis decimated those endowments. In order to provide
some relief to students seeking loans, the DOE announced on November 20,
2008, that it would purchase as much as $6.5 billion in federally guaranteed
loans made during the 2007–8 academic year. This action was intended to add
liquidity to the FFEL program for private sector student loans.
In 2007, in the midst of the student loan scandals, Sallie Mae was the target
of a $25 billion buyout proposal from a consortium composed of private equity
investors J.C. Flowers and Freidman, Fleischer & Lowe, as well as Bank of
America and JPMorgan Chase. However, after the passage of the College Cost
Reduction and Access Act of 2007, Sallie Mae expressed concern that higher
financing costs might eliminate its profitability. Sallie Mae soon concluded
that it could no longer make a profitable student loan based on the reductions
in subsidies, and it decided to reduce its involvement in the student loan mar-
ket. This considerably undercut the value of Sallie Mae’s franchise, and the
private equity buyout fell apart.
On top of these problems, Sallie Mae was hit with a $2.5 billion bill for a
buyback of its own stock that had been hedged with a forward purchase agree-
ment with Citigroup. Sallie Mae had thought that the hedge would protect it
from an expected increase in its stock price during a buyback program, but
the problems in the student loan market caused the price of its stock to plunge
instead. As a result, Sallie Mae lost $1.6 billion in the fourth quarter of 2007.
Sallie Mae increased its loss reserves by $575 million, but reported another
loss in the first quarter of 2008 in the amount of $104 million. Company of-
ficials again warned that Sallie Mae was unable to make profitable loans under
existing conditions. Sallie Mae wrote off 3.4 percent of its student loans in
2008 and issued another profit warning for its projected 2008 earnings, which
turned out to be lower than expected.
Sallie Mae faced increased funding costs caused by the credit squeeze and
lower credit ratings during the subprime crisis. In a reprise of Jeffrey Skilling’s
famous cursing of a questioner during a financial analysts’ conference call,
Sallie Mae’s chief executive officer, Albert L. Lord, became frustrated and let
loose with an expletive that shocked the audience listening in on an earnings
conference call report. The SEC also investigated whether Sallie Mae execu-
tives had sold a large number of shares on the basis of inside information.
Sallie Mae’s stock fell by almost 56 percent in 2008. It was able to borrow
$1.5 billion from Goldman Sachs for student loans in January 2009, but that
did not rally its shares. Still, Sallie Mae continued to be the largest private
lender in the $85 billion student loan market. It made $6.3 billion in student

Securitization 391
loans in 2008. Citigroup made a much smaller $1.8 billion in such loans that
year, while JPMorgan Chase only made $1.1 billion. The student loan market
continued to falter as the subprime crisis worsened. The newly installed Obama
administration dealt Sallie Mae a further blow by announcing that it would
seek to sideline private lenders in the student loan market by further reducing
their profit on the spread between borrowing costs and lending rates. This ef-
fectively constituted nationalization of much of the student loan business.
There was some residual business left for Sallie Mae in the servicing of
student loans. Sallie Mae announced in March 2009 that it would make private
student loans requiring students to pay interest while still attending school.
Repayment terms were also shortened from fifteen to thirty years to five to
fifteen years. Sallie Mae estimated that private student loan volumes would
fall by 30 percent but that these changes would make it easier to securitize
its loans.
As 2009 began, the DOE was planning to buy some $60 billion of student
loans in order to assure the availability of funds for students. The Obama
administration announced after taking office that it intended to increase the
DOE’s share of the student loan market from 20 to 80 percent by July 2010,
an increase that would require a commitment of some $100 billion in tax-
payer funds. To assist that effort, the House of Representatives passed a bill
that would shut out private lenders from the student loan market. During the
subprime crisis the Fed also created a Term Asset-Backed Securities Loan
Facility, which allowed the Federal Reserve Bank of New York to purchase
newly issued, highly rated, asset-backed securities collateralized by student
loans as well as other receivables. In the meantime, students borrowed more,
increasing the value of educational loans taken out by 25 percent for the aca-
demic year 2008–9.
Subprime Lending
Subprime Loans
No uniform standards have been established for classifying loans as subprime,

but they are generally viewed as loans extended to borrowers who fall into one
of three categories: (1) those with a poor credit history; (2) those with no credit
history; and (3) those who have existing credit but are overextended (some
subprime borrowers were “house rich” but “cash poor” because of equity built
up in their house7).8 Factors considered in classifying a loan as subprime include
credit history, household debt-to-income ratio, and combined loan-to-value
ratio for home equity loans and other mortgage debt. FICO credit scores are
also used to identify subprime borrowers. Named for its creator, the Fair Isaac
Corporation, FICO is a method of calculating a borrower’s creditworthiness
based on information gathered by credit bureaus, credit card usage, payment
history for debts, previous bankruptcy, judgments, and liens.

FICO uses a scale ranging from 300 to 800. The higher the FICO score, the
more creditworthy the borrower is in the eyes of a lender. The median FICO
score in the United States is about 720. Generally, a FICO score below 660 is
viewed as subprime, although many lenders accepted a lower number during
the subprime crisis. About 27 percent of Americans have a FICO score below
650, and 15 percent have a score below 600.9 In contrast to subprime borrow-
ers, “prime,” or “A credit,” borrowers, as they are known in the trade, have
strong credit scores, allowing them to obtain the most competitive interest
rates and mortgage terms.
Like other lenders, the subprime lender makes profits based on the spread
between the funds it borrows and those that it lends borrowers. Because of
the high risk of default among subprime borrowers, interest rates on subprime
loans are much higher than those charged to more creditworthy borrowers—
differences of three or four percentage points between prime and subprime
borrowers were common. Those differences, and the high origination and other
fees charged for subprime loans, tempted lenders to originate large amounts
of subprime loans.
Consumer Protection Legislation
Congress passed several consumer protection statutes related to consumer

lending and residential mortgages. The Truth in Lending Act passed in 1968
sought to ensure SEC-style full disclosure of all loan terms to consumers.
Lenders were required to disclose the full cost of the mortgages that they issued
and in a uniform manner so that consumers could, presumably, comparison
shop for better terms. However, the formula required for those disclosures
was so complicated that it became burdensome and unworkable. Congress
was then forced to adopt the Truth in Lending Simplification and Reform Act
to simplify those disclosures.
Another consumer protection measure was the Fair Credit Reporting Act,
which allowed consumers to examine their credit reports and to correct inaccu-
racies. This was important for consumers because most lenders relied on those
reports in making credit decisions on mortgages. The Equal Credit Opportunity
Act was passed in 1974 to prohibit discrimination in credit extensions on the
basis of sex or marital status, race, religion, or national origin. Among other
things, this meant that the incomes of unmarried persons applying jointly for
credit had to be combined for credit purposes.
The Real Estate Settlement Procedures Act of 1974 (RESPA) required
disclosure to consumers of the costs associated with real estate mortgage
closings. This allowed borrowers to assess their settlement charges, which
sometimes were inordinately high. The disclosures were required in every
settlement involving a federally insured mortgage loan. Unfortunately, these
and other disclosure requirements turned residential real estate settlements into
a marathon, requiring the signing of dozens of documents filled with legalese

Securitization 393
so dense that no one but a real estate lawyer could understand it. Many states
also required disclosures for environmental problems, termites, radon, and other
defects, laying the groundwork for lawsuits by dissatisfied homebuyers.
Predatory Lending Practices
Because subprime borrowers were desperate for credit, they were targets for
predatory lending practices that state and federal governments tried to curb.
The Office of the Comptroller of the Currency (OCC) identified several prac-
tices deemed predatory: loan “flipping,” which involved frequent refinanc-
ings in order to generate additional fees; hidden financing fees; unreasonable
loan terms, such as negative amortization, which made it impossible for the
borrower to repay the loan; balloon payments to force early refinancing; and
inadequate disclosures of the risks and costs of financing transactions. Another
abuse was the offering of a single premium credit life insurance, rather than
monthly premiums over the life of the loan. This was disadvantageous to the
borrowers because they often refinanced or sold the house before paying off
the mortgage, and they had already invested money in what then turned out
to be unneeded insurance.
Third-party mortgage brokers also presented the OCC with concerns over
loan origination practices. Mortgage brokers were paid a fee for each loan
that they originated. Consequently, they had a strong incentive to overlook
any flaws in the credit history of borrowers. Federal bank regulators warned
that banks should ensure that they had properly documented subprime loans
and that reduced documentation loans should be extended only where there
were mitigating factors, such as prior favorable history with the borrower.
State regulators also issued warnings to state-regulated lenders concerning
“no doc” and “low doc” subprime loans, which were followed by NINJA (no
income, no job, no assets) loans.
More than 75 percent of subprime loans had an adjustable rate. Their initial
“teaser” interest rates were often below existing market rates. This allowed
borrowers to leverage the amount that they could borrow because loan amounts
were set by the amount of interest payments that their income could support.
However, the teaser rate could increase by three to six percentage points in
as little as two years. Moreover, some two-thirds of subprime mortgages had
prepayment penalties that deterred refinancing into lower-cost mortgages.
Federal banking regulators issued a warning in June 2007 that expressed
concern over particular adjustable-rate mortgages (ARMs), including loans
with teaser rates that were adjusted after a short period into a variable index
interest rate plus an additional number of points. For example, the “2/28 ARM”
had a fixed rate for two years and then adjusted to a large premium over some
existing rate index for the remaining twenty-eight years of the loan. The spread
over the index rate used to set the adjustable rate usually ranged from 300 to
600 basis points, called “payment shock” in the business.

Nontraditional mortgages began to appear in greater numbers in the form

of interest-only mortgages (with no or delayed principal payments) and pay-
ment option ARMs (“pick-a-pay”), in which the borrower could choose from
a number of payment options. One option allowed the borrower to make a
minimum payment that was less than the declared interest rate, resulting in
negative amortization. After a specified period, the borrower’s payments
were increased to an amount that would allow full amortization of the loan
balance over the remaining loan term. That increase could be substantial, as
the regulators pointed out using an illustration with a 41 percent increase
in a borrower’s monthly mortgage payment at the conclusion of the initial
two-year period. These payment option ARMs were sold to some 2 million
homeowners, and they became known as the “Typhoid Mary” of mortgages
during the subprime crisis. Nearly $750 billion in these mortgages were issued
between 2004 and 2007. The World Savings Bank in California, a part of the
Golden West Financial Corporation, heavily marketed the pick-a-pay loans.
Its founders, Marion and Herbert Sandler, sold those operations to Wachovia
for $26 billion in 2006. After Wachovia failed and was taken over by Wells
Fargo during the subprime crisis, losses on loans from Golden West mortgages
were estimated to be as much as $36 billion.10
Another type of ARM that concerned regulators was that in which the
payment amounts on the reset date were not capped, which could result in
payment shock. More innovations followed in the form of debt consolida-
tions secured by a home mortgage, on which interest payments were tax
deductible. “Reverse mortgages,” which allowed elderly homeowners to take
drawdowns on the equity accumulated in their homes over the years, were
widely sold to seniors by retired actors. Such payments assured participating
seniors a guaranteed source of income. Reverse-mortgage payments were
not taxable, and repayment did not have to be made until the senior died or
sold the residence.
Still another matter of concern in the subprime market was the “piggyback”
loans, in which the borrower was allowed to borrow 80 percent of the value
of the home being mortgaged. A separate loan would give the borrower the
additional 20 percent needed for the down payment. This, of course, meant
that the borrower had no “skin in the game” and could simply walk away
from the mortgage if the value of the house dropped—which was no deter-
rent to the mortgage lenders. The head of Countrywide Financial Group even
asserted in 2003 that low-income borrowers should no longer be required to
make any down payments on their home mortgages. This would make pig-
gyback loans unnecessary, but left the borrower with no capital at risk in the
event of a market downturn. Concern was also raised over “no money down”
mortgages because of their high default rate. Some of those mortgages were
made possible by nonprofit organizations, which were funded by home build-
ers and homeowners seeking to sell a property. The sellers were thereby able
to provide enough money for the borrower to obtain a loan from the FHA,

Securitization 395
which required a minimum down payment of 3 percent. The FHA sought to

eliminate such programs in 2008 because of their high default rate.
The Home Ownership and Equity Protection Act of 1994 (HOEPA) tried
to limit some predatory lending practices. It applied to residential mortgages
with interest rates in excess of 8 percent over that of Treasury securities of
comparable maturity or a spread of 10 percent for second mortgages. The statute
applied to mortgages in which fees (including credit insurance premiums) and
points payable by the borrower totaled more than $510 (adjusted annually for
inflation) or 8 percent of the total loan amount. This legislation provided for a
cooling-off period of three days, during which the borrower could rescind the
loan. HOEPA also required various disclosures by the lender to the borrower
for covered loans, some of which were rather elementary. For example, the
lender was required to disclose that it would have a mortgage on the home
and that the borrower could lose the residence, and any money put into it, if
mortgage payments were not made.
HOEPA banned some predatory practices for covered loans, including bal-
loon payments, negative amortization (which involves monthly payments that
do not fully pay off the loan over its life and that cause an increase in total
principal debt), most prepayment penalties, and due-on-demand clauses. The
law prohibited lenders from making loans based on the collateral value of a
residence property without regard to the borrower’s ability to repay the loan.
It prohibited refinancing within twelve months of origination of a loan, unless
the new loan was in the borrower’s best interest. The OCC also prohibited na-
tional banks from making consumer loans that were supported predominantly
by the expected sales price in foreclosure and that were issued without regard
to the borrower’s ability to repay the loan.
States began to pass laws that sought to prohibit predatory lending practices.
North Carolina was the first to pass such a statute in 1999, one that prohibited
“flipping,” a practice in which mortgages were repeatedly refinanced, each with
new upfront fees. The North Carolina legislation required counseling for loans
with high fees or interest rates and forbade balloon payments and negative
amortization. The statute prohibited lenders from requiring upfront lump-sum
premium payments for credit insurance, allowing monthly payments instead.
It also required lenders to consider the borrower’s ability to repay before mak-
ing a home loan. The North Carolina statute caused a drop in lending in that
state, touching off a debate over whether the statute was denying credit to the
needy or doing what it was intended to do by prohibiting predatory loans that
consumers could not afford.
In 2001 Georgia passed a Fair Lending Act, requiring lenders to be able to
prove that all home refinancing of mortgages of less than five years in dura-
tion provided a “tangible net benefit” to the homeowner. In other words, the
refinancing had to have some beneficial purpose, and not be just a way to
generate fees for mortgage brokers and lenders. New Jersey passed a similar
requirement in 2003, called the Home Ownership Security Act. Other state

legislation was directed at particular predatory lending practices. Some states

sought to regulate mortgage brokers, who were the ones most frequently
engaging in predatory lending activities. By 2004, thirty-two states and the
District of Columbia had enacted some form of legislation regulating preda-
tory lending practices.
A massive lobbying effort was carried out by the mortgage financing industry
to stop the advance of other state anti–predatory practice laws that threatened to
curb subprime lending. A study by the Center for Public Integrity reported that
the top twenty-five mortgage originators had spent some $370 million to fend
off regulation between 1999 and 2009. One of the largest subprime lenders,
Ameriquest Mortgage Company, spend $20 million on campaign donations
and other lobbying efforts that resulted in the easing of predatory practice
laws in New Jersey and Georgia. It was aided in that effort by Countrywide
Financial, Citigroup, and the Mortgage Bankers Association.
Federal Preemption
Concerns over the penalties in the Georgia Fair Lending Act, which included
criminal punishment, caused many lenders to withdraw from the subprime
market in that state. The OCC and the Office of Thrift Supervision then pre-
empted the Georgia statute—which meant that the federal government was
preventing the states from exercising jurisdiction over federally regulated banks
on this issue. The state then ruled that state banks would also be exempted
from its reach, but nonbank mortgage lenders and finance companies were
still subject to its provisions.
To prove that it was a tough enforcer, and that state regulation was un-
necessary, the OCC filed an enforcement action in 2000 against the National
Bank in Tilton, New Hampshire, for engaging in predatory lending practices.
The bank agreed to refund $300 million to clients and was subject to several
restrictions on its future lending practices. In another case brought in 2003,
the OCC entered into a consent decree with the Clear Lake National Bank
that required it to pay more than $100,000 to thirty of its borrowers because
of abusive home equity loans.
The FDIC suffered some embarrassment when it was reported that a bank it
had taken over after a highly publicized failure had continued making predatory
subprime mortgages totaling more than $550 million. The bank that failed was
the Superior Bank in Illinois. Those loans were originated while the FDIC was
winding down its operations and were sold to another bank. Some of those
loans had interest rates of more than 12 percent and were defaulting in large
numbers. The FDIC settled a case brought by Beal Bank, which bought those
faulty mortgages, for $90 million.
The Federal Trade Commission (FTC) jumped into the predatory lending
fray and charged that First Alliance Mortgage Corporation had engaged in
predatory lending practices by concealing high fees and interest rates from

Securitization 397
borrowers. The company paid $60 million to settle those charges. In September
2002, the FTC announced a settlement with Citigroup that required the bank
to reimburse borrowers $240 million as a result of predatory lending practices
by a firm acquired by Citigroup, Associates First Capital Corporation, which
was selling overpriced credit insurance. This was the largest settlement in FTC
history. Citigroup also agreed to lower its cap on lending fees from 5 percent
to 3 percent of the loan value.
Thereafter, in 2004, the Justice Department and the Fed entered into a settle-
ment with Citigroup over predatory lending practices by one of its affiliates.
The bank agreed to pay $70 million and became subject to a cease-and-desist
order. In that case, the Baltimore-based CitiFinancial Credit Company, a unit
of Citigroup, had required loan applicants to have cosigners and had required
both the applicant and cosigner to purchase expensive credit insurance.
CitiFinancial was also charged with making loans without considering the
borrower’s ability to repay. Compounding these violations was the fact that
CitiFinancial employees tried to conceal these practices from investigators.
Citigroup also agreed to a $20 million settlement with the North Carolina
attorney general over charges that some 9,000 borrowers were deceived into
purchasing expensive credit insurance.
ABN Amro agreed to pay $41.3 million in a joint settlement with the Justice
Department, the OCC, and HUD to settle charges that it had falsified mortgage
loan documentation by submitting 28,000 falsified insurance certificates to
the FHA. The SEC brought charges against Los Angeles area brokers who
persuaded their customers to refinance their homes with subprime mortgages.
The brokers then invested the loan proceeds in high-risk securities that were
not suitable for those investors.
The states continued their attacks on predatory lending practices. In 2002,
Household International, the parent company of Household Finance, which
was not subject to the OCC preemption order, entered into an $844 million
settlement with state attorneys general and banking regulators from all fifty
states, as a result of its predatory lending practices. Later, in January 2006,
Ameriquest agreed to pay $325 million to attorneys general and banking
regulators in forty-nine states to settle predatory lending charges.
Democratic members of Congress had long been seeking to adopt preda-
tory lending laws, copying the statute passed in North Carolina. However,
the Bush administration and Alan Greenspan, the Fed chairman at the time,
resisted those efforts. Greenspan also pushed back against efforts to impose
such restrictions by regulations on banks under the Fed’s regulatory umbrella.
Legislation was introduced in Congress to overrule the OCC preemptive order,
but the subprime lobby assured that it did not pass.
The states were still seething over the OCC’s preemption order, though it
won support from a Supreme Court ruling in 2007 that held that the mortgage
lending business of a national bank, whether conducted through the bank
itself or through a subsidiary, was subject to OCC control and not that of the

states.11 Regulatory officials from all fifty states opposed that position. North
Carolina’s attorney general, Roy Cooper, remarked that the Supreme Court’s
decision “took fifty sheriffs off the beat at a time when lending was becom-
ing a wild west.”12 Ironically, that case had been brought by Wachovia, which
was headquartered in North Carolina. Wachovia had brought the case against
Michigan regulators, who were seeking to regulate a subsidiary of Wachovia,
the Wachovia Mortgage Corporation. Not long after the Supreme Court’s de-
cision, Wachovia suffered massive and destructive losses from its subprime
lending activities, and it was taken over by Wells Fargo.
New York attorney general Eliot Spitzer separately challenged the preemp-
tive order of the OCC. He had been able to bulldoze other federal regulators
out of his way, including the SEC, but the OCC was another matter. Spitzer
challenged the OCC by suing First Horizon, a subsidiary of a national bank,
charging predatory practices. He sought only a nominal fine, bringing the case
only as a test of the OCC’s preemptive powers. Spitzer also demanded that
the New York Clearing House, which handled clearing for eight large banks,
turn over information on credit scores and other lending data. The SEC had
wilted from Spitzer’s attacks on its competence, but one federal regulator,
the OCC, rejected Spitzer’s rhetoric. Julie L. Williams, the acting comptrol-
ler of the currency, had Spitzer permanently enjoined by a federal court from
investigating low-income lending practices by national banks.
Of course, the OCC’s action now raises the question of whether lax bank
regulation led to the subprime crisis and whether Spitzer could have exposed
those problems earlier. In the event, the Supreme Court decided to review
the issue of whether the injunction was appropriate and ruled that it was not
insofar as it prevented Spitzer from bringing an enforcement action against a
national bank for violation of state law. Nevertheless, the New York attorney
general was not allowed to visit or demand the books and records of banks,
limiting his ability to bring such actions. The ruling in the Spitzer case was
not handed down until June 29, 2009. By then the subprime crisis had swept
aside any concern for consistency or duplicative regulation, but Spitzer was
unable to savor the victory because he had already been driven from office in
disgrace. Ironically, Spitzer’s last act as a crusader, before his resignation, was
the publication of an op-ed piece in the Washington Post, in which he decried
the OCC’s preemption order, asserting that state attorneys general had observed
a large spike in predatory lending, but that they were prevented by the OCC
from attacking such practices. The OCC published a rather tart response, claim-
ing that most of the predatory lending problems emanate from state-regulated
institutions over which it had no control and to which its preemption order
did not apply. The Dodd-Frank Act that was passed by Congress in July 2010
imposed some restrictions on the OCC’s preemption authority.
The states persisted in their efforts to regulate subprime lending. Bank
of America settled predatory lending charges in the third quarter of 2008
involving Countrywide, which it had acquired during the subprime crisis.

Securitization 399
That case was brought by attorneys general from fifteen states. In settling that
case, Bank of America agreed to modify as many as 400,000 mortgages by
refinancing them at lower interest rates and through a reduction of principal.
However, Bank of America encountered some difficulties in carrying out that
agreement because some of the loans had been securitized, and some of the
investors who had purchased those obligations objected to any modifications
that reduced their returns.
Vermont was taking a victory lap as the subprime crisis wound down in
August 2009. A front-page article in the Wall Street Journal noted that this
state had one of the lowest default rates on home mortgages in the country—3
per 100,000 homes versus Nevada, number one with 396 defaults per 100,000
residences. That success was attributed to a state statute that required lenders to
tell borrowers if their rates were substantially higher than those at other lenders
and that imposed fiduciary duties on mortgage brokers in favor of the home
buyer. Vermont banks also rarely securitized the loans that they originated,
giving them a stake in ensuring the quality of the credit.13
Fannie Mae and Freddie Mac
Fannie Mae purchased or guaranteed $270 billion in subprime loans between

2005 and 2008. It was noted at the time that Fannie Mae was taking on con-
siderably more risk through that activity. Even earlier, an article in the New
York Times on September 30, 1999, presciently pointed out that an economic
downturn could cause those loans to default and could require a government
rescue of Fannie Mae.14 Peter Wallison, a fellow at the American Enterprise
Institute, and a longtime and frequent critic of Fannie Mae and Freddie Mac,
also cautioned that this subprime exposure at Fannie Mae and Freddie Mac
would set the stage for another government bailout like the one that occurred
during the savings and loan crisis in the 1980s. That prophecy turned out to
be correct.
By 2004, Fannie Mae and Freddie Mac accounted for $2.65 trillion of the
outstanding $4.1 trillion in mortgage-backed securities. Concerns continued
to be raised that these two GSEs were not managing their risks properly. In
2003, Freddie Mac announced that it was restating its earnings for the prior
three years. That announcement seemed innocuous at the time because the
company stated that it was making those restatements in order to reflect higher
earnings from its derivatives operations. However, a few months later, Freddie
Mac fired three executives because of their involvement in previously undis-
closed accounting irregularities. That caused Freddie Mac’s stock to drop by
16 percent in one day.
Freddie Mac understated its earnings by $5 billion for 2000 to 2002, in order
to smooth its earnings and meet financial analysts’ consensus estimates. The
agency fired its president, David Glenn, and its chairman and CEO, Leland
Brendsel, and its chief financial officer (CFO), Vaughn Clarke, were forced

to resign. Brendsel also agreed to a settlement with OFHEO over his role in
that scandal. This included the return of $10.5 million in compensation that
Brendsel received while he worked at Freddie Mac. He also agreed to waive
claims for an additional $3.4 million in compensation. Freddie Mac paid a
record $125 million fine to OFHEO, which blamed management misconduct
for the faulty accounting. Freddie Mac paid another $50 million to settle SEC
charges over its accounting misstatements.
In the meantime, Fannie Mae asserted that it did not have any mortgage-
related accounting problems like those at Freddie Mac. However, late in 2003,
Fannie Mae disclosed that, in fact, it had its own accounting problems and
that it had made some computational errors. That proved to be a giant under-
statement. Fannie Mae had voluntarily registered its securities with the SEC
and, coincidentally, filed its first annual financial report with that agency in
March 2003. This allowed the SEC to charge that Fannie Mae had misstated
earnings over a four-year period, requiring a restatement of $9 billion—which
would eliminate 40 percent of the GSE’s profits between 2001 and 2004. Fan-
nie Mae agreed to pay $400 million to settle SEC and OFHEO charges over
that conduct, but OFHEO was still criticized for not responding in a timely
fashion to those announcements. Critics also complained that OFHEO was
too small and understaffed to regulate these two giant GSEs, having only 140
employees and an insufficient budget of $30 million.
Fannie Mae disclosed additional accounting problems in March 2006, and
OFHEO issued a report on Fannie Mae in May 2006. That report concluded
that Fannie Mae’s CEO, Franklin Raines, and other executives at Fannie Mae
had acted in a manner that “was inconsistent with the values of responsibility,
accountability, and integrity.”15 The OFHEO report found that Fannie Mae’s
accounting was motivated by a desire to portray the company as a consistent
and stable generator of earnings, and it was also encouraged by an executive
compensation scheme that rewarded management for meeting earnings per
share goals, a “metric” that could be manipulated by management. OFHEO
concluded that Fannie Mae had a “dysfunctional” accounting policy, and it
strongly condemned Raines’s management, noting that he benefited greatly
from the accounting manipulations.16
Franklin Raines had been a highly paid executive at Fannie Mae. His earn-
ings rose from $4.5 million in 2000 to $11.6 million in 2003. Those earnings
were based on the inflated profits reported as a result of the accounting ma-
nipulations. Raines was raised in poverty in Seattle, and he fought his way
up to attend Harvard and receive a Rhodes scholarship. Raines served as the
White House budget director during the Clinton administration. Fannie Mae
became a dumping ground for Democratic politicians, and Raines was given
a lucrative post there. He and two other senior executives agreed to pay OF-
HEO $31.4 million to settle charges over his responsibility for the accounting
problems at Fannie Mae. Raines agreed to pay $24.7 million of that amount,
but the payment was to be made mostly by forgoing the exercise of vested

Securitization 401
stock options and other benefits that turned out to have little, if any, value after
Fannie Mae failed. The taxpayers also had to foot the legal bills, which totaled
over $6 million, of Raines and other Fannie Mae executives who were targets
of lawsuits over the accounting irregularities at the firm.
A massive report was prepared for the Fannie Mae board of directors by War-
ren Rudman, the former senator from New Hampshire, on Fannie Mae’s past
accounting abuses. Although it found that most of Fannie Mae’s accounting prac-
tices had not been in accordance with generally accepted accounting principles,
the Rudman report largely exonerated Raines of any wrongdoing. However, it
did accuse him of creating a “culture” that allowed improper activities. Blame
for the accounting problems focused on Fannie Mae’s CFO, J. Timothy Howard,
and the controller, Leanne Spencer. The accounting manipulations were said by
a Treasury official to be the result of an “earnings at any cost” culture.17
Raines later became an adviser to Barack Obama during his presidential
campaign and was the target of attack ads by the campaign of his Republican
opponent, Arizona senator John McCain. Raines was embarrassed by disclo-
sures that Angelo Mozilo, the head of Countrywide, had made personal efforts
to arrange mortgages for Raines and James Johnson, Raines’s predecessor at
Fannie Mae and another Democratic politician who was paid a substantial
salary there, $21 million in his last year of employment. The Raines and
Johnson loans were arranged through a “friends of Mozilo” lending program
at Countrywide that made mortgage loans on favorable terms to members of
Congress and other prominent individuals. Raines denied any favored treat-
ment on the loans, but congressional investigators claim to have discovered
documents indicating that the loans were made on preferential terms.
After the subprime crisis peaked in September 2008, it was revealed that
two other Fannie Mae executives received loans from Countrywide. One was
Daniel Mudd, who was ousted from his position as CEO when Fannie Mae
was taken over by the federal government. The other Fannie Mae executive
receiving a loan from Countrywide was Jamie Gorelick, another former Clinton
administration official at Fannie Mae, who received a bonus of almost $800,000
from Fannie Mae in 2003. It is unclear how Gorelick qualified for her position
at Fannie Mae as she had no financial experience. A congressional investiga-
tion in 2010 revealed that, in total, Countrywide gave “VIP” mortgage loans
on favorable terms unavailable to the general public to over 150 individuals
working at Fannie Mae. They included several directors, executives and lower
level employees. Several of those loans were made about one year before Fan-
nie Mae agreed to buy large amounts of Countrywide loans.
In 2004, Treasury Secretary John Snow urged that the size of the mortgage
portfolios of Fannie Mae and Freddie Mac be reduced because interest rate
changes could cause large losses at those GSEs and unhinge markets. That effort
got nowhere. Efforts by the Bush administration to regulate Fannie and Freddie
like banks were blocked by the strong opposition of Democratic Senator Chris
Dodd, Senator Chuck Schumer, and Representative Barney Frank.

Accounting problems continued at the GSEs. Freddie Mac announced that

it was delaying its 2005 results because it was having difficulty valuing its
assets. Fannie Mae disclosed more accounting problems in March and May
2006, and then it announced that it would not be filing financial statements
until 2007. Fannie Mae paid $800 million to its accountants in 2006 for their
work on straightening out its records. In 2008, OFHEO warned Fannie Mae
and Freddie Mac that they were improperly applying accounting rules to value
their portfolios for earnings purposes.
The GSEs and their regulation were further criticized by Greenspan for
not imposing higher capital requirements on Fannie Mae and Freddie Mac
in order to cushion their creditors from any losses that might occur in the
event of a mortgage market crisis. Congress set those capital limits at very
low levels. However, both firms contended that they were properly managing
their risks through hedging and other activities and that, therefore, their capital
was adequate.18 Legislation was introduced in 2004 to transfer OFHEO to the
Treasury Department, but that legislation was not enacted before both Fannie
Mae and Freddie Mac failed at the height of the subprime crisis.
Collateralized Debt Obligations
One popular form of securitization for subprime mortgages was collateralized

debt obligations (CDOs). These were simply packaged subprime mortgage
pools that were securitized and sold off to investors who bought participation
certificates entitling them to some portion of the proceeds from the pooled
mortgages. Those participation certificates were sold to those investors in un-
derwritings conducted by investment banking firms such as Lehman Brothers,
Bear Stearns, and Merrill Lynch. A trustee was appointed to manage the pool
for investors, and a servicing agent collected and distributed the mortgage
payments. This process of packaging subprime loans and securitizing them
became almost mechanized.
Complicating these instruments even more were “CDO squared” instru-
ments, which were pools of CDOs, rather than the underlying mortgages, which
were securitized. They were followed by “CDO cubed,” which were pools
of CDOs squared. The financial engineers also developed synthetic CDOs.
These instruments do not contain mortgages or CDOs. Rather, they were credit
protection devices that protected against loss from a CDO instrument. The
return on a synthetic CDO is determined by reference to the performance of
a portfolio of loans. The CDO is synthetic in that the issuer does not actually
have to own the loans. The credit exposure is synthetically created by enter-
ing into a credit-default swap, in which one party pays a periodic fee, and
the other pays any losses in principal on the nominal loans. As described in
Chapter 7, a synthetic CDO was the subject of a sensational case brought by
the SEC against Goldman Sachs.

Securitization 403
Monoline Insurers
Another credit enhancement for subprime mortgage securitizations was finan-

cial guarantee insurance policies issued by “monoline” insurance companies.19
These insurance companies initially insured state and municipal bond offerings
against default. That insurance allowed municipalities to issue triple-A-rated
bonds, which lowered their funding costs because they could not otherwise
obtain such a rating. This business was successful for the insurer because the
default rate on municipal securities was less than 1 percent of the outstanding
issues each year.
The monoline insurers branched into guaranteeing subprime mortgage
securitizations when those instruments became a popular product, a deci-
sion that they would later regret. Like the rating agencies, monolines used
mathematical models to predict the expected rate of defaults on the subprime
securitizations as the actuarial basis for setting premium payments. Those loss
rates were quite low in the rising housing market before the subprime crisis
because of low teaser interest rates that had not reset, and a rising residential
market allowed frequent refinancing that could be used to defer defaults. As
a result, the monoline models proved inadequate in predicting the losses that
would be experienced during the subprime crisis.
One of the larger monoline insurance companies was MBIA, which was
based in Armonk, New York, and had offices around the world. MBIA’s
revenues increased by 140 percent between 2001 and 2006 as its structured
finance business grew. Another large monoline insurer was Ambac Financial
Corporation, based in New York City. Both companies started as insurers of
municipal bonds, which still accounted for much of their business. However,
they fatefully sought to expand their business into CDOs involving subprime
mortgages. That business, initially, appeared to be lucrative and to pose little
risk to the insurance companies because of their modeling abilities.
As the subprime crisis began to bloom, Ambac was insuring some $40 bil-
lion in debt linked to subprime mortgages. However, it had too little capital to
cover its exposures when the subprime crisis fully blossomed. It tried to ease
that situation by reinsuring about 5 percent of its portfolio, transferring that
risk to another company, Assured Guaranty. Ambac also reached an agreement
with Citigroup that took Ambac off the hook for most of the insurance that
it had issued for some mortgage-backed securities held by Citigroup. Ambac
agreed to pay $850 million in settlement of $1.4 billion in claims held by
Citigroup.
Ambac gave a profit warning that it would be experiencing large losses
in the fourth quarter of 2007. The company’s CEO, Robert J. Genader, was
removed, and the company cut its dividend by 67 percent. Ambac later an-
nounced a $3.26 billion loss in the fourth quarter of 2007 as the result of a
$9.21 billion writedown on its credit-related insurance activities in subprime

securities. The company had been downgraded from triple-A status by the
rating agencies after Ambac concluded that the market would not absorb a $1
billion issue that was needed to increase the company’s capital.
The situation at Ambac continued to deteriorate. It reported a loss of $1.66
billion in the first quarter of 2008, causing the value of its shares to fall by 43
percent. In March 2008, Ambac sought to recapitalize through an injection
of more than $2 billion from eight banks, including Citigroup and UBS. New
York governor Eliot Spitzer had been involved in pressuring the banks to assist
Ambac because the failure of a monoline insurer would raise financing costs for
municipalities that used its insurance to boost their credit ratings. That effort
resulted in only a $1.5 billion equity financing by Ambac in March 2008, rather
than the $2 billion it sought, and which was about half what many thought
was needed. Ambac announced the declaration of a six-month moratorium on
writing insurance for structured finance instruments. The value of Ambac’s
shares fell by 20 percent after its capital-raising effort fell short. It had some
$140 billion outstanding in structured finance exposures. Ambac stopped its
dividend payments in 2008, and it reported a loss of $5.6 billon for the year.
Ambac then set off howls of outrage when it announced in January 2009 that
it was paying four executives bonuses totaling $3 million, even though the
value of the company’s shares had fallen by 96 percent during 2008.
MBIA’s capital was also badly damaged by losses from defaulting mort-
gages. The company’s stock price was down 70 percent in 2007, and it was
in danger of losing its AAA credit rating. The loss of that rating would harm
its ability to continue to act as an insurer. MBIA announced a six-month self-
imposed sabbatical from insuring further structured finance instruments.
In order to shore up its capital base, MBIA obtained an investment from a
private equity group, Warburg Pincus, which purchased $500 million in MBIA
stock in December 2007 for $31 a share. That was not a good investment. The
price of MBIA’s stock dropped to $13.61 a share in early April 2008. MBIA
was able to preserve its credit rating as 2008 began through a $1 billion issue
of “surplus notes” with a 12 percent yield in January 2008. MBIA also reduced
its quarterly dividend by 62 percent. Those efforts did not stop the hemor-
rhaging. MBIA reported a first-quarter loss in 2008 of $2.41 billion. Strangely,
that was considered good news by the market because traders thought that the
company would be able to retain its AAA credit rating. However, Moody’s
announced a review of MBIA’s credit rating, and as losses mounted in June
2008, MBIA lost its triple-A rating.
MBIA and Ambac were both downgraded to AA, and Standard & Poor’s
warned of further downgrades. Moody’s cut MBIA’s ratings again on Novem-
ber 7, 2008, dropping its debt rating to junk bond status and pushing its insur-
ance business rating down from A2 to Ba1. That downgrade set off triggers
in some of its contracts, which placed more pressure on the firm’s liquidity
resources. MBIA asked Fitch Ratings, one of the smaller rating agencies, to
stop rating some of its securitized debt because of MBIA’s disagreement over

Securitization 405
the capital requirements imposed by Fitch. MBIA thought those requirements

were too high. MBIA’s losses increased in the third quarter of 2008, and Am-
bac received a further ratings downgrade. MBIA lost $806 million in the third
quarter and posted a loss of $2.7 billion for the year.
MBIA announced in February 2009 that it was dividing itself into two arms,
one for municipal bond insurance and the second for structured investments and
other nonmunicipal business. It denied that this was an effort to create a “good
bank–bad bank” structure. A group of eighteen banks sued MBIA over this
division of assets, claiming that it defrauded them of coverage. Third Avenue
Management also sued MBIA, claiming that the split was “asset stripping”
that harmed bond holders. MBIA kept the CDO guarantees, and the National
Public Finance Guarantee Corp. took the state bond insurance business. MBIA
posted a first-quarter loss in 2010 of $1.48 billion.
Monoline problems spread. In March 2008 Wilbur L. Ross invested $1 bil-
lion in Assured Guaranty, the fifth-largest bond insurer, which had taken over
the insurance on some of Ambac’s subprime underwriting. Its triple-A rating
was put on a credit watch by Moody’s Investors Services in July 2008, as was
Financial Security Assurance. Another monoline insurer, Syncora (formerly
known as SCA), was in trouble over its guarantees for $140 billion in bonds
covering municipal debt and structured finance. It was ordered by insurance
regulators in April 2009 to stop making payments on claims. That action then
triggered $18 billion in credit-default swaps written on Syncora’s debt. How-
ever, the net exposure on those swaps was only $1 billion.
Another bond insurer, ACA Capital Holdings, reported a third-quarter loss
in 2007 of $1 billion and was facing a ratings downgrade that would destroy
its ability to meet collateral requirements. In that event, banks that insured
SIVs and ABCP investments with that company would have to move those
investments back onto their books. ACA Capital Holdings reached a settle-
ment with clients covering $69 billion of its coverage for subprime mortgage
defaults. The company agreed to turn over control of itself to those creditors
and continued to underwrite insurance on municipal bonds. ACA Financial
Guarantee Corporation had more than $60 billion of credit-default swaps that
it had underwritten but was unable to pay, including a large amount held by
Merrill Lynch to cover its exposure from subprime instruments. Merrill Lynch,
which was itself in extremis during the subprime crisis, had other problems
with subprime insurance. It sued Security Capital Assurance, a bond insurer,
claiming that it had reneged on credit-default swaps covering $3.1 billion in
mortgages.
Insurance claims for individual mortgages were also rising. The largest of
those insurers, MGIC Investment Corp., lost hundreds of millions of dollars
during the crisis, including $340 million in the second quarter of 2009. It
posted twelve straight quarterly losses and did not return to profitability until
the second quarter of 2010.
In October 2008, Fed chairman Ben Bernanke proposed the creation of a

government bond insurer that would insure securitized mortgages, but that
program was not pursued. Warren Buffett announced that he was entering the
bond insurance business and would use his strong capital base to compete with
the faltering bond insurers. Buffett made that announcement at the request of
Eric R. Dinallo, the New York State superintendent of insurance. Buffett’s new
monoline insurance company, Berkshire Hathaway Assurance, raked in $400
million in premiums in the first quarter of 2008, making his new company the
largest in the industry.
The market for new municipal bond offerings was frozen because of con-
cerns over the stability of MBIA and other municipal bond insurers. Suspicions
were raised that the monolines would be unable to meet their obligations in
the event that municipal bond defaults increased. Such defaults were expected
to increase because of declining municipal revenues caused by the economic
downturn accompanying the subprime crisis. The value of many municipal
bonds dropped sharply, and many municipalities were unable to borrow in
the municipal bond market because of a lack of viable insurance. This put a
further squeeze on municipal finances, which were already suffering as the
recession bit into their revenue streams. In July 2009, the State of California
was reduced to writing IOUs to pay its bills. The state budget deficit in Cali-
fornia had grown to $19 billion in 2010.
Another part of the mortgage insurance business continued to be affected
by the subprime crisis. Mortgage insurers that provided private mortgage
life insurance for homeowners were in a panic as the third quarter of 2008
began. They tightened insurance standards for mortgages to such an extent
that many potential borrowers were excluded. Commercial credit insurers
were also facing difficulties. Their products included credit insurance for ac-
counts receivables, accounts receivable puts, single buyer credit protection,
and credit-default swaps.
Credit-Default Swaps
The higher interest rates charged to subprime borrowers made those loans
attractive to lenders, but they still had to contend with the embedded risk of
high default rates. This required some credit enhancement to make them mar-
ketable, such as a credit-default insurance or a credit-default swap (CDS) that
would serve the same purpose. One scholar gave the following description of a
CDS in which Bank A is trying to hedge its exposure from a $10 million loan
to company B “by going to C, a dealer in these swaps, who agrees to pay the
$10 million to A if B defaults, in exchange for paying an annual premium to
C for the protection. A will want collateral from C to be sure it’s good for the
debt.”20 The CDS proved a popular instrument. Outstanding notional value
of the CDS market hit $45 trillion in the first half of 2007. That market grew
to cover $65 trillion in debt at year-end 2007. The actual net exposure was
estimated to be a much smaller, but still hefty, $2.3 trillion.

Securitization 407
Indexes were created to track and trade the value of mortgaged-backed se-
curities based on CDS. In 2001, JPMorgan Chase created the High Yield Debt
Index composed of 100 high-yield single name corporate debt instruments. That
index was followed in 2004 by the Dow Jones CDX Indexes across several
areas covered by CDS, including everything from investment grade to junk
bonds. IBOXX and Trac-X were providing debt basket quotes and other debt
indexes included CMBX prepared by Markit Partners and the ABX, which
referenced fifteen to twenty debt instruments. The ABX became known as the
“fear” index because it reacted to adverse subprime events. In 2007 the Chicago
Board Options Exchange (CBOE) began trading credit-default options that
were automatically exercised upon the occurrence of specified credit events.
Another CBOE product was credit-default basket options, which were cash-
settled options based on a basket of at least two reference entities. Futures on
CDS were also traded on the Chicago Board of Trade (CBOT).
An issue had arisen in prior years over whether CDS and similar instruments
were insurance that was subject to state insurance laws and reserve require-
ments. The state insurance regulators, specifically in New York, concluded that
such instruments were not insurance. In order to be insurance there must be,
in insurance parlance, an “insurable interest” on the part of the beneficiary. In
the case of a CDS, there need be no insurable interest because the CDS was
not tied to any specific casualty event directly affecting the party receiving
the protection. Rather, payment was made on the CDS even if there was no
injury to the protected party. Dinallo, the New York State superintendent of
insurance, testified in Congress in October 2008 that only about 10 percent
of CDSs were used for protection. The rest were speculative bets. Legislation
passed in 2010 prohibited CDSs to be treated as insurance.
Mortgage Brokers
Mortgage brokers comprised a large part of the mortgage origination process

in the run-up to the subprime crisis. They were paid a fee by banks for origi-
nating mortgages, which were usually based on the payment of a yield spread
premium (YSP) above the “par” rate otherwise offered by the lending bank
to consumers, who make their loan application directly to the bank. Some 90
percent of all mortgages originated by mortgage brokers carried a YSP, and it
was estimated that, leading up to the subprime crisis, some 60 percent of all
mortgages were arranged by a mortgage broker.
There were some early warning signs that mortgage brokers might be more
motivated by fees than sound lending practices. Citigroup announced in August
2001 that it was suspending its relationships with 4,000 mortgage brokers
because of integrity concerns. Those concerns grew during the subprime
crisis. Senator Charles Schumer from New York charged that Countrywide,
the nation’s largest home mortgage lender, was providing inappropriate incen-
tives to mortgage brokers to steer borrowers to take out high-cost mortgage

products. Mortgage brokers were being given 1 percent of the value of a

subprime loan containing a three-year term for prepayment penalties and an
additional incentive for subprime loans with a high reset rate after the teaser
rate expired on an ARM.
JPMorgan Chase announced in January 2009 that it was discontinuing
the use of third-party brokers to originate even prime mortgages. Instead, it
would use its own employees to originate loans. In light of the then-ongoing
subprime crisis, the Treasury Department recommended, in March 2008, the
creation of a regulatory scheme for mortgage brokers. That program would be
administered by the states, but would be overseen by a federal agency called
the Mortgage Origination Commission (MOC). MOC would set licensing
standards for mortgage brokers and review state implementation of those
licensing standards and regulation of mortgage brokers. Such a program was
established through legislation passed in 2010.
Another flaw in the securitization process was due diligence on the quality
of the mortgages placed in the CDOs. The investment bankers outsourced this
task to various firms, including Clayton Holdings, the Bohan Group, and Opus
Capital Markets. Those firms only sampled the documentation and reviews
were, by necessity, only cursory. However, Clayton claimed it warned the
rating agencies that many loans had deficiencies.
Nonbank Subprime Lenders
Traditionally conventional mortgage lenders—banks and thrifts—avoided the

subprime market because of the risks it posed. Instead, nonbank lenders serviced
that market. Subprime lending had historically been limited to the local loan
shark, pawnshops, and personal loan companies. One of the latter, Beneficial
Finance, began to make second mortgages available to subprime lenders in
the 1960s. Beneficial carefully expanded that portfolio and within a decade
was making profits of $100 million a year, with a loss rate of just 1 percent on
defaults.21 In 2003 HSBC, one of the world’s largest banks, acquired Beneficial
for $14 billion as well as the Household International finance company. Those
acquisitions made HSBC the second-largest consumer lending company in the
United States, with almost a thousand branches in forty-six states. However,
those acquisitions proved almost fatally costly. HSBC wrote off $11 billion in
losses from that unit in 2007 and announced in February 2009 as losses contin-
ued to mount that it was cutting back its U.S. consumer finance operations.
A principal source of subprime lending in the 1990s were the mortgage
banks, financial institutions that focused their business on residential loans,
particularly subprime loans, whose fees and rate spreads were the greatest.22
These mortgage lenders were “nonbank banks” that were able to escape regula-
tion because the regulatory definition of a bank is that it is an institution that
both accepts demand deposits and makes commercial loans. The nonbanks did

Securitization 409
not take deposits and made only residential loans and, therefore, fell outside
the definition of a bank.23
In the 1980s, regulators had to contend with a number of nonbank banks that
offered services similar to those of regulated banks but that were not techni-
cally considered banks because they did not accept “demand” deposits that
could be immediately withdrawn on the demand of the depositor. Rather, those
nonbank banks offered NOW (negotiable order of withdrawal) accounts with a
technical notice requirement that meant that the deposits could not be legally
withdrawn on demand, although in practice they were. Other nonbank banks
avoided regulation as banks in the 1980s under the second prong of the bank
definition because they took deposits but did not make commercial loans.
The Fed tried to regulate these nonbank banks in 1984 by adopting rules
defining NOW accounts as demand deposits and broadened the definition of a
commercial loan to include commercial paper and other money market instru-
ments bought by nonbank banks, but excluded personal, family, and household
loans.24 The Supreme Court ruled in 1986 that the Fed did not have the power
to extend the statutory definition of a bank in such a manner.25 Congress then
passed legislation that included NOW accounts as a form of demand deposit.
However, that change did not extend to mortgage lenders that were not accepting
deposits in any form or did not make commercial loans. The mortgage companies
were able to exploit that loophole by funding their residential mortgage loans
from their own borrowings from banks and other commercial lenders. Those
unregulated institutions would be at the heart of the subprime crisis.
The nonbank mortgage lenders included the likes of First Plus, Cityscape
Mortgage, Ameriquest, Long Beach Mortgage, Option One Mortgage, and
the Money Store. Eight of the top subprime lenders were nonbanks based in
southern California. This was a fiercely competitive market and an appealing
one for those entrepreneurs because of the spreads. Little regard was given to
risk. Between 1993 and 1997, the volume of new home-equity loans raised by
subprime nonbank companies increased tenfold, to $64 billion. A Wall Street
Journal article reported in 1998 that many of those loans were made to “bor-
rowers without a prayer of getting money from a bank.” A financial analyst
“remembers visiting the companies and ‘I’d sit there and watch the underwriters
approve a credit: You’d look on the credit report and the guy would have two
prior bankruptcies.’”26 DiTech Funding Corporation of Irvine, California, made
high-fee loans of up to 125 percent of the resident’s value of a home.
These subprime mortgage lenders had a financing problem. They could not
take deposits to fund the mortgages. Rather, they were dependent on loans
from firms willing to finance their operations, and that is what led to the perfect
storm that became the subprime crisis. Prudential Securities led the way into
this nonbank “warehouse” financing. Other investment banks soon found it
to their liking because they could charge high rates to the nonbanks, which
could still profit from the even higher interest on the subprime mortgages that
they originated or purchased.

This “warehouse” financing also provided access on the part of the invest-
ment banks to the mortgages being generated by the nonbank mortgage lend-
ers, which could then be securitized by the investment banks for more fees.
The result was a giant, and ever-growing, merry-go-round of warehouse loans
by investment banks, followed by loan originations by the mortgage lenders,
which were then sold to the investment banks, which was followed by their
securitization, which generated funds for a new round of originations.
The subprime mortgage market experienced a boomlet in the mid-1990s
due to these securitizations, but it encountered a crisis between 1998 and 1999
when the bottom fell out of the market. It then became difficult to securitize
subprime loans, and that funding source dried up, for a time, for the nonbank
lenders. The securitization certificates sold to investors in the securitizations
also became highly illiquid. That event bankrupted dozens of subprime lend-
ers, many of which had become public companies. Firms suffering during this
first subprime crisis included Southern Pacific Funding Corporation, Aames
Financial Corporation, First Plus, AmerCredit, IMC Mortgage, PacificAmerica
Money Center, and Unites Cos Financial Corporation. As one report noted:
A number of factors have contributed to the recent decline in the health of

the subprime industry. Increased competition is one of the most important
factors. In 1994, there were only ten companies in the subprime lending
business. By March of 1998, that figure had grown to fifty. Increased
competition in the subprime market caused deterioration in overall
credit quality. The proliferation of subprime lenders forced companies
to go deeper into the credit pool to find customers. This reduction in
credit quality has increased the risk of default. Moreover, consumer
defaults have been on the rise as the average American has taken on an
increasing amount of debt. The industry was also hurt by the entrance
of inexperienced subprime lenders who incorrectly evaluated customers’
credit ratings and thereby made bad loan decisions. As the stock prices
of subprime lenders dropped because of financial difficulties, institutions
were less willing to provide the capital to subprime companies to finance
further loans.27
In the wake of this first subprime crisis, the SEC warned accounting firms
that they should more carefully scrutinize the way subprime lenders booked
profits from loans that were being securitized. The SEC was particularly con-
cerned with “gain-on-sale” accounting for booking profits from securitizations.
That accounting treatment recognized the gain on the transaction immediately
even though the gains would be actually realized over several years. The Fi-
nancial Accounting Standards Board (FASB) then proposed tougher accounting
treatment for such transactions.
No other lessons appear to have been learned from that event, perhaps
because the press mostly ignored it, focusing instead on the then-ongoing
Asian financial crisis that had spread from Thailand to Russia and caused the

Securitization 411
collapse of the Long-Term Capital Management hedge fund. Another factor

limiting coverage was the then-small size of the subprime mortgage market.
At that time only about 10 percent of outstanding mortgages were subprime.
Even so, the big investment banks should have learned a lesson from the first
subprime crisis. First Union, the giant North Carolina bank that later merged
with Wachovia, purchased the Money Store in 1998 for $2.1 billion. Just two
years later, it was forced to take a $1.8 billion charge as a result of losses
from that operation. Wachovia, Merrill Lynch, and others afterward purchased
nonbank subprime lenders that destroyed their businesses during the subprime
crisis that emerged in 2007.
First Alliance, a California subprime lender, was able to secure a $150
million warehouse credit facility from Lehman Brothers Holdings as 1999
began. Lehman also invested in two subprime loan originators, Aurora Loan
Services in Littleton, Colorado (in 1997), and BNC Mortgage (in 2000) in
Irvine, California. Bear Stearns was also committed to the subprime non-
banks, providing large amounts of warehouse financing, and it created its own
subprime lender, EMC Mortgage, which survived the first subprime market
panic with little damage.
The first subprime crisis was written off as an accounting problem and a
hundred-year storm in the financial markets that was not likely to be repeated.
The larger investment banks believed that they could assess the risks of the
market and structure their securitizations in a way that would make them
highly marketable. The investment banks came to believe that their more
sophisticated risk management techniques would shield them from the losses
suffered by the pioneer nonbank subprime lenders that failed in that first crisis.
They were horribly wrong.

10. Prelude to a Crisis
Panics and Bubbles
Some History
Periodic market bubbles, panics, recessions, and depressions have long plagued
the world. The Tulip mania in the Netherlands in 1636 and the South Seas
bubble in England in 1720 are well-known examples. Similar economic dis-
turbances also erupted in the New World, with ten depressions there between
1762 and 1837. The Panic of 1792 (due to the speculation of William Duer
and Alexander Macomb against stock held by the Bank of New York) and
recessions in 1796, 1802, 1807, and 1837 were particularly troubling to the
new American republic. They were followed by panics in 1857, 1873, 1884,
and 1893—the last of which resulted in an economic downturn that lasted
until 1897 and was called the “Great Depression” until that title was claimed
by the depression of the 1930s.
These panics were usually attended by a loosening of credit and an economic
boom that ends with a high-profile business failure, a process recognized by
Hyman Minsky and thus known as the “Minsky Moment.”1 A boom in Western
land sales preceded the Panic of 1837. President Andrew Jackson tried to dampen
that land speculation with his 1836 Specie Circular, which required public land
purchases to be paid for in specie. That was a shock to the economy, but the
panic itself was triggered in 1837 by the failure of two large cotton firms. Their
demise reverberated throughout the economy. Over 250 firms failed in New
York, and real estate values fell by the then-considerable $40 million.
The Panic of 1857 followed an economic boom that was reflected in a high
volume of trading in stocks and bonds. The precipitating events in that panic
were the sinking of the SS Central America, which was carrying gold stocks
from California, and the failure of the Ohio Life Insurance and Trust Com-
pany, which was caused by embezzlement by its cashier. The Panic of 1873
followed a boom in railroad financing. The precipitating event was the failure
of Jay Cooke & Company, a brokerage firm named after its founder, who had
financed much of the Union’s expenses in the Civil War. The Panic of 1884
412

Prelude to a Crisis 413
was preceded by speculative operations in the stock markets and a Florida land
boom. Its precipitating event was the failure of Grant & Ward, a brokerage
firm in which the former Union general Ulysses S. Grant was a partner. The
Panic of 1893 followed the failure of the National Cordage Company.
The nation experienced thirteen banking panics between 1814 and 1914, but
the worst during that period was the Panic of 1907, a seminal event in American
financial history.2 It was triggered by a stock manipulation in copper that failed
and brought down the Knickerbocker Trust Company. The manipulation was
an attempted “bear squeeze” of naked (uncovered) short-sellers in the stock
of the United Copper Company. This meant that the conspirators were selling
stock that they did not own in the hope that the stock would decline in value
so that they could buy it back for less than the price at which they had sold it.
The short-sellers prevailed in that contest, and they would reappear to play a
role in the subprime crisis in 2008.
The failure of the Knickerbocker Trust Company endangered other trust
companies and led to a panic. J.P. Morgan, who had just rescued New York
City after it was unable to place a bond offering, took charge of the chaos that
followed Knickerbocker’s downfall. He famously locked a group of bankers
in his library until they devised a rescue plan and, with more of Morgan’s firm
leadership, order was restored. The sudden and unexpected nature of the 1907
panic and its severity led to a lengthy congressional investigation that eventu-
ally resulted in the creation of the Federal Reserve (Fed) several years later.
The Stock Market Crash of 1929
Until the subprime crisis, the country’s most horrifying financial experience
came in the wake of the stock market crash of 1929, followed by the Great De-
pression. Stock prices on the New York Stock Exchange (NYSE) had doubled
in the 1920s, and volume exploded. Securities prices increased by more than
37 percent in 1927 and grew another 43 percent in 1928. The crash of the stock
market in 1929 was unexpected, despite some warning signs, like the failure of
the Credit Anstalt in Austria on May 8, which had been involved in the carry
trade of borrowing short and lending long. Yet the market seemed unconcerned,
though there were a few naysayers. Paul Warburg, a well-known financier, and
one of the founders of the Fed, warned on March 8, 1929, that the speculative
mania in the stock market would result in a market collapse that would be fol-
lowed by a nationwide depression. On September 5, 1929, Roger Babson, a
popular investment adviser, predicted that the stock market would soon crash.
That caused a brief sell-off, but the market did not begin to react sharply until
October 1929, culminating in “Black Thursday,” when millions of shares were
thrown on the market and panic gripped the nation. Efforts by bankers to per-
form a 1907 J.P. Morgan–style rescue by supporting the market failed. The Dow
Jones Industrial Average fell 23 percent on October 28–29, 1929. A decline of
that magnitude would not be repeated until 1987 and 2008.

Unlike in earlier panics, it is difficult to isolate any one event that could be
said to have caused the Great Depression. Economists have generally agreed
that the 1929 crash was but one of many factors leading to that depression.
Certainly, the Fed failed to fulfill its mission before and after the crash. It had
raised rates in order to slow the market, pushing the call market rate (the rate
at which brokers obtained loans for their customer’s margin positions) to 20
percent for this short-term money. However, those high rates only brought
more money into the call market.
After the market crashed, the Fed injected $500 million into the banking
system and, in a series of eleven cuts, reduced interest rates from 6 percent
to 1.5 percent between 1929 and 1931. It shocked the economy by raising
interest rates from 1.5 percent to 3.5 percent in October 1931, before reduc-
ing them to 2.5 percent in 1932. The Fed also required banks to increase their
reserves in 1936, just as the country appeared to be recovering. That action,
and President Franklin D. Roosevelt’s continued attacks on business manag-
ers, including a “soak the rich” tax bill, helped send the economy into another
tailspin in 1937. The country was saved not by government intervention but
by the outbreak of World War II.
Inflation
The country experienced one of its greatest economic expansions in the 1960s.
The result was a high rate of inflation, and the economy went into recession in
1969. By May 1970, the value of stocks listed on NYSE had been cut nearly
in half. Later in the 1970s, the country was confronted with “stagflation,” a
unique combination of low growth and high inflation, for which the government
had no cure. The stock market continued to lag, and Time magazine published
a cover story titled “The Death of Equities: How Inflation Is Destroying the
Stock Market.”
A new Fed chairman, Paul Volcker, finally stepped in to apply some harsh
medicine in the form of interest rate increases that were unprecedented in
magnitude. Volcker’s actions sent the economy into a recession that was one
of the worst since the Great Depression of the 1930s. Unemployment reached
10 percent nationwide in 1982, but the unemployment rate in Detroit was
an astounding 25 percent. Nevertheless, the economy did recover and a new
era of prosperity began. Future Fed chairmen ever after adopted Volcker’s
method to combat inflation by raising interest rates to punitive levels, even
at the expense of a recession. His success persuaded the Fed that it could
use interest rate hikes to dampen inflation or burst bubbles and interest rate
cuts to boost the economy when it appeared headed toward recession. In the
post-Volcker era, interest rate manipulations, good in theory or not, proved
too blunt an instrument and only served on more than one occasion to ex-
acerbate market bubbles when rates were too low and to nearly wreck the
economy when too high.

The Stock Market Crash of 1987
Another seminal event in American financial history was the stock market
crash of 1987. As in the Panic of 1907 and the Crash of 1929, the sell-off
that began on October 14, 1987, had no forewarning. On that day, the stock
market began its worst-ever one-week decline until the subprime crisis. The
market continued to plunge on October 15 and 16. On October 19, 1987, the
Dow experienced a new historical record for a one-day decline in percentage
and absolute numbers; the Dow fell by 508 points, more than 20 percent of
its market value. Over $500 billion in stock value evaporated. Until events in
2008 required a reconsideration, October 19, 1987, was considered by many
to be the worst day ever on Wall Street.
The actual cause of the 1987 crash is uncertain. The Fed had raised short-
term interest rates from 5.5 to 6 percent in September; some claimed that a
merchandise deficit was the cause, while others thought that a proposal to
eliminate tax benefits for corporate takeovers was the culprit. A presidential
commission headed by Nicholas Brady, a future secretary of the treasury,
was created to conduct a study of the 1987 crash. The Brady Commission’s
report concluded that the development of financial futures contracts and re-
lated trading strategies had resulted in a convergence of the futures and stock
markets. The Brady Commission believed that the two markets had become
disconnected during the October sell-off, exacerbating price declines and
destabilizing the market.
The Brady Commission recommended several steps to prevent such panics
in the future, but the only action actually implemented was the imposition of
trading collars or “circuit breakers,” as they were called, which caused trad-
ing to be stopped when certain levels of volatility were reached. The circuit
breakers proved unpopular, and NYSE announced its intention to discard them
in 2007, almost twenty years to the day from when they were first proposed.
They were no longer needed to allow orderly trade processing because NYSE
had massively increased its capacity to deal with the sort of large-volume trad-
ing that might trigger those limits. In 1987, NYSE could handle only about
95 electronic messages per second, but by 2007 it was able to handle 38,000
messages per second, as a result of computer enhancements. However, the
extreme price volatility that occurred during the subprime crisis halted the
elimination of those circuit breakers. NYSE announced new circuit breaker
limits on December 31, 2008. Among other things, those limits would halt
trading for an hour in the event of an 850-point decline in the Dow Jones
Industrial Average before 2 p.m. Eastern Standard Time. Collars were also
placed on “program” traders, large traders responding to computer-generated
trading signals. Such trading was thought to have disrupted the market during
the 1987 crash. However, NYSE discarded those program trading restrictions
after twenty years, just as the subprime crisis was getting under way.
The October 1987 crash had few long-term effects on the economy. It

took the stock market two years to recover its pre-October 1987 levels, but
not before a minicrash that occurred on October 13, 1989. On that day, the
stock market lost $190 billion in value, of which $160 billion was lost in the
last ninety minutes of trading. However, this plunge appeared to be merely a
random event, and the market shrugged it off.
Another matter for Brady to attend to when he became treasury secretary
was the Latin American sovereign defaults of the 1980s. Loans by U.S. banks
to those countries had paid high returns, but the ten largest banks in the United
States had made loans totaling $50 billion to countries that were about to
default in 1982. About half of those loans were made to Mexico. Bank of
America was among those suffering from doubtful debts in Latin America and
other underdeveloped countries. It had reserved $1.1 billion for loan losses on
those debts. That was not a good thing because the bank had written off over
$5 billion in bad loans over the previous five years. Citigroup reserved $3
billion and Chase Manhattan $1.7 billion for their bad loans. Those amounts
seem small in light of the massive writedowns during the subprime crisis,
but concern was raised at the time that the entire U.S. banking system might
implode. The banks resolved the Latin American loan crisis by restructur-
ing the defaulted loans, which included extending maturity dates, reducing
interest rates, and even allowing some forgiveness of principal. Secretary
Brady then began a program of securitizing these loans off the banks’ books
through so-called Brady bonds that packaged the loans for sale to investors,
and the crisis passed.
In response to those problems, Congress passed the International Lending
Supervision Act of 1983, requiring banks to increase their loss reserves for
loans to countries that were delinquent or in default. The legislation stated
somewhat ironically it now appears that it “is the policy of the Congress to
assure that the economic health and stability of the United States and the other
nations of the world shall not be adversely affected or threatened in the future
by imprudent lending practices or inadequate supervision.”3 It was lack of
supervision and imprudent lending practices that became the watchwords for
Congress and regulators in the wake of the subprime crisis
Trouble Abroad
In the early 1990s, except for a brief recession in the United States, economic
concerns were focused abroad. The Mexican peso collapsed in 1994, setting
off a financial crisis that had worldwide effects. The 1994 crisis was touched
off by the Mexican government’s effort to gradually devalue the peso without
panicking investors. That effort failed, and the Mexican economy suffered a
severe slump. That crisis spread to other countries in Latin America.
The International Monetary Fund (IMF) put together a rescue package for
several countries, and the crisis gradually subsided. By then, the IMF had be-
come an international emergency lender of last resort for defaulting countries.

However, it was unpopular in many of the countries that it rescued because

the IMF imposed conditions (“conditionality”) on its loans, which were in-
tended to make the borrowing government more fiscally responsible. These
conditions ranged from cutting government spending on social programs to
increasing taxes—conditions viewed as impinging on the borrowing nation’s
sovereignty and sometimes leading to violent protests.
Another economic crisis broke out in Thailand in 1997, after that country
experienced an unprecedented economic boom financed through borrowings
that could not be supported. The panic spread quickly to Indonesia and then to
South Korea. That situation was remedied by a $40 billion IMF rescue effort
that sought to stabilize the currencies of the affected countries. However, the
effects of that crisis continued to reverberate around the world for more than
a year. This “Asian flu” spread to Russia in 1998, where the economy nearly
collapsed as a result of flaws in its financial system and a drop in oil prices.
Those problems in turn touched off a near crisis in the United States.
In August 1998, the Dow Jones Industrial Average fell by 1,000 points over
a few days. The Russian crisis had caused a worldwide “financial freeze, as
one asset class after another became highly illiquid, and investors piled into
the treasury market.”4 Fed chairman Alan Greenspan, Treasury Secretary
Robert Rubin, and Deputy Treasury Secretary Larry Summers appeared on
the cover of Time magazine and were lionized as the “Committee to Save
the World” for their efforts in containing the Asian flu. The accompanying
article stated:
In late-night phone calls, in marathon meetings and over bagels, orange juice and
quiche, these three men—Robert Rubin, Alan Greenspan and Larry Summers—are
working to stop what has become a plague of economic panic. Their biggest shield is
an astonishingly robust U.S. economy. Growth at year’s end was north of 5%—double
what economists had expected—and unemployment is at a 28-year low. By fighting
off one collapse after another—and defending their economic policy from political
meddling—the three men have so far protected American growth, making investors
deliriously, perhaps delusionally, happy in the process.5
The members of the Committee to Save the World would also be front and
center during the subprime crisis.
Long Term Capital Management (LTCM), the highly leveraged hedge fund,
lost nearly 90 percent of its $4.8 billion in capital, largely from losses stemming
from a default on Russian government bonds. The Fed helped arrange a rescue
of LTCM. Although that bailout did not involve any government funds, it was
highly controversial because it was thought that the Fed was adding liquidity
to the market and signaling that it would rescue any large investor caught in a
liquidity trap or faced with unexpected losses. This infusion of liquidity was
called the “Greenspan Put.”6 Another bit of fallout from the LTCM rescue was
that Bear Stearns was the only major investment bank invited by the Federal
Reserve Bank of New York to participate in the rescue that refused that request.
This refusal created a lot of lingering resentment and animosity on Wall Street

against Bear Stearns, which did not stand it in good stead when it was failing
during the subprime crisis.
The government has adopted a “too big to fail” approach at other times in
history. Government loan guarantees for Lockheed in the 1970s and Chrysler
in the 1980s are two prominent examples. The government also stepped in to
save the depositors of the Continental Illinois Bank in the 1980s, extending
deposit protection beyond the normal limits of the Federal Deposit Insurance
Corporation (FDIC) and effectively nationalizing that bank. Those actions
were based on a belief in some financial quarters that some firms were “too
big to fail” because their demise would set off a market panic, cause the
failure of other firms, and do severe damage to the economy. Those views
were supported by prior panics in which a single failure or small group of
failures resulted in panics, recessions, and depressions. An opposing school
of thought argued that such interventions were improper and created a “moral
hazard” that would encourage irresponsible actions by large firms because of
their belief that the government would step in and save them. It also relieved
shareholders and creditors of the obligation to monitor management to protect
their investments.
Run-Up to the Real Estate Bubble
Breaking the Dot.Com Bubble
In the 1990s a bull market developed that lasted almost ten years. During that
boom, stock market indexes exploded in value and reached heights undreamed
of in earlier years. The Dow Jones Industrial Average doubled and then doubled
again, reaching a record high of 11722 on January 14, 2000. Trading volume
on the exchanges also ballooned. Average daily trading on NYSE was more
than 800 million shares per day in 1999. NASDAQ average daily trading
volume exceeded a billion shares.
This market bubble was spurred by the growth of the high-tech “dot.com”
companies that sprang up as computer technology and use of the Internet
expanded. Many of the initial public offerings (IPOs) by these often-untested
start-up companies were “hot issues” that traded up rapidly in secondary
markets immediately after their issuance. More than 250 Internet-related IPOs
took place in 1999, with an average 84 percent increase in price on the first
day of trading.
The stock market run-up caused Fed chairman Alan Greenspan great con-
cern. He warned of a bubble in the stock market in 1994, but his concerns
were largely ignored. In 1996, Greenspan again warned that the stock market
was overinflated and asserted that this bubble was the result of “irrational
exuberance.” Greenspan was a bit premature in his predictions (by three
years), but he later began to act on his concern that a sudden bursting of the
bubble would send the country’s economy into a recession. Actually, he made

sure that his warnings became a self-fulfilling prophecy. Greenspan broke the
market single-handedly through a series of punitive interest rate increases that
began on June 30, 1999. Although the market resisted those attacks for a time,
it began its decent in April 2000. Over $8 trillion in stock values evaporated
in the ensuing downturn.
Greenspan claimed that his interest rate increases would assure a “soft
landing” for the economy after the bubble was eventually burst. In actuality,
the Fed’s actions helped push the country into a near recession. Realizing his
error, Greenspan reversed course and started cutting interest rates, starting on
January 3, 2001. That action was too little, too late, and was compounded by
the terrorist attacks on September 11, 2001, which not only brought down the
World Trade Center but also nearly emptied the financial district in New York
and sent stock market prices plunging.
The NASDAQ Composite Index fell 25 percent during one week in April
2000, declining from a high of 5048 on March 24, 2000, to a low of 1114 after
the market crash. The Dow Jones Industrial Average fell to 7286 in 2002, and
the S&P 500 from its high of 1527 in 2000 to 777 in 2002. The Fed’s interest
rate hikes were responsible for reversing the market’s course, but the economy
was also suffering from the effects of those increases. The economic decline
in 2002 did not meet the official definition of a recession because there were
not two quarters of decline in a row, but there were two quarters of decline
separated by a quarter of low growth. The catastrophic terrorist attacks on
September 11, followed by the Enron-era scandals, further undermined con-
fidence in the economy. Greenspan testified before Congress in July 2002 that
“infectious greed” had invaded corporate America.
Interest Rates
Greenspan’s reductions in interest rates eventually pushed them down to levels

unseen in forty-five years. The Fed also announced on January 30, 2002, that
it planned to maintain its low-interest-rate policy for the near future. The stock
market was bolstered by this change in direction by the Fed on interest rates
as well as by the large tax cuts that the newly inaugurated president, George
W. Bush, was able to pass in Congress.
The NASDAQ index increased by 50 percent in 2003, and the Dow rose
25.3 percent during the year. Gold prices reached $414 an ounce in December
2003, the highest level in eight years (gold prices exceeded $1,200 per ounce
in the wake of the subprime crisis). The NASDAQ index reached a thirty-year
high on January 12, 2004. The national unemployment rate was 5.6 percent in
March 2004, and retail sales climbed by 3 percent. The gross domestic prod-
uct (GDP) increased at an annual rate of 6.1 percent in the first half of 2004.
Manufacturing activity was at a twenty-year high. The economy gave every
appearance of having entered a new period of prosperity.
The law of unintended consequences then asserted itself. The Fed’s low-

interest-rate policy set off a residential housing market boom, during which
housing construction mushroomed and home prices climbed sharply. New
home construction in 2000 increased at the fastest rate since 1986. In 2000,
total mortgages outstanding in the United States were valued at $5.2 trillion,
and nearly 10 million new loans were originated, with a value of $1.6 tril-
lion. About half those originations were sold into the secondary market. More
than 40 percent of mortgages originated with Fannie Mae, Freddie Mac, and
Ginnie Mae.
In March 2001, housing prices were 8.8 percent higher than the year before.
Fannie Mae, Freddie Mac, Ginnie Mae, and the Federal Home Loan Banks
(FHLBs) increased their mortgage business by almost $85 billion in the first
quarter of 2001. New mortgage originations in 2001 increased to $1.5 tril-
lion, of which about $900 billion was for new mortgages and the rest was for
refinancing. On average, homeowners owed about 45 percent of the value of
their homes to a mortgage lender, an increase over 32 percent in 1985; in 2008
it rose to 54 percent.7
In his testimony before Congress in July 2001, Greenspan stated that rising
housing prices had created “a buffer of unrealized capital gains” that were be-
ing captured through mortgage refinancing and home sales. He asserted that
this capital was protecting the economy even while the stock market was in
a slump. Low interest rates were also spurring subprime lending. New home
sales set a record in 2002, when the average interest rate on a thirty-year
residential mortgage fell to 6.07 percent. Mortgage refinancing continued its
boom as interest rates fell even lower and housing prices continued to rise,
freeing up cash for consumers. The dollar value of second mortgages increased
by 20 percent in 2002.
Interest-only mortgages were growing in popularity. Washington Mutual
lent about $1 billion per month in 2002 for such mortgages, which usually
paid a monthly spread over LIBOR (the London Interbank Offered Rate),
which is a popular benchmark of current interest rates used as a guide by many
banks to set loan rates and to reset rates on loans with floating interest rates.
In 2002, the interest rate payments on such mortgages were as low as 3.25
percent. Interest-only mortgage payments dropped to 2.8 percent as LIBOR
fell from 6.37 percent in 2001 and then to 1.625 percent in 2003. Washington
Mutual increased the percentage of its option ARMs from 5 percent in 2003
to 40 percent in 2004.
In 2004, the amount of outstanding interest-only, negative amortization,
and similar exotic mortgages totaled about $800 billion. Merrill Lynch urged
investors to take out an interest-only mortgage in order to free up funds that
could be invested elsewhere.8 Other interest-only advocates pointed out that
there was not much amortization in the early years of a thirty-year mortgage
anyway, so why worry about the absence of any amortization in an interest-
only mortgage that simply deferred amortization?
Between September 2002 and September 2003, new mortgage originations

totaled $1.2 trillion and refinancing totaled about $3 trillion. The percentage
of American families that owned their own homes reached 69.2 percent in
2003. Sales of existing homes set a record in both 2002 and 2003. More than
7 million homes were sold in 2003, including 1.09 million new homes, which
was another new record. Lower interest rates meant that consumers could
borrow more and pay more for their residences, which they did. The average
price of a new home increased by 5.8 percent in 2002, reaching a new high of
$218,900. Home prices climbed at a rate of 7.4 percent in 2003.
In June 2004 sales of existing housing set an all-time record and new home
starts were the second most numerous in history. Housing prices more than
doubled in California and Florida between 2001 and 2006. The number of
homes valued at over $1 million grew, reaching 0.6 percent of the housing
market in 2003, about half of them in California, New York, and Florida. “Flip-
ping” real estate became a national pastime as speculators from every walk
of life tried to cash in on the bubble by purchasing and reselling residential
property. Reality television shows were devoted to showing how to buy and
quickly fix up existing properties for flipping.
Banks and other lenders jumped in to assist by refinancing mortgages on a
massive scale as interest rates dropped, generating large fees for those finan-
cial institutions. Banks, online firms, and mortgage brokers pushed consum-
ers to take out loans by offering quick application processes, often online,
with reduced documentation requirements. As one book related, Americans
had developed a “house lust” that was becoming an obsession dominating
everyday life.9
Although critics were concerned that a real estate bubble was growing,
Greenspan discounted that possibility for some time. It was not until June 30,
2004, that he seems to have awakened and began raising interest rates. On
that date, the Fed funds rate was raised from 1 percent to 1.25 percent. This
deflated the stock markets, but they were able to recover. Greenspan raised
interest rates by another 0.25 percent on August 10, 2004. The Dow Jones
Industrial Average surged after the rate hike, but then began drifting and
became volatile.
The pace of growth in the housing market temporarily slowed. The rate of
sales of existing homes fell in July 2004 by 6.4 percent over the previous month,
and median home prices did not rise. Ignoring that signal of a downturn, the
Fed responded with another rate hike of 0.25 percent on September 21, 2004.
At this point, the interest rate on a fifteen-year residential mortgage averaged 5
percent. GDP grew 4.4 percent in 2004, the fastest rate in five years. Corporate
profits were up and growing at the strongest rate since 1992. However, there
was a disconnect in the money markets, where long-term interest rates were
not rising in tandem with short-term rates.
Bank loans in default reached a six-year low in December 2004. A slightly
bullish stock market was twenty-seven months old as 2005 began. Housing
starts hit a twenty-one-year high in January 2005, giving rise to more specula-

tion in the press that a residential real estate bubble was beginning to inflate.
Greenspan joined the chorus of concern over a bubble, stating that there was
“froth” in the real estate market and that the boom was not sustainable. He
would not go so far as to admit the existence of a national real estate bubble,
but he did recognize several localized bubbles. His statements had no immedi-
ate effect on the real estate bubble. The Fed continued to raise interest rates,
lifting the Fed funds rate to 2.75 percent on March 22, 2005, but the market
continued its boom. The chairman of the president’s Council of Economic
Advisers, Ben Bernanke, opined in 2005 that while housing prices had risen
by some 25 percent during the preceding two years, “these price increases
largely reflect strong economic fundamentals.”10
Sales of new homes set another new record in April 2005. The Fed an-
nounced that it planned to continue to increase interest rates and did so on
May 3, 2005, by 0.25 percent. Inflation was low, except in the energy markets.
Natural gas prices were rising. Crude oil prices reached $58 per barrel in April
2005 and continued to climb, reaching $70 per barrel in August, after Hurricane
Katrina shut down drilling rigs in the Gulf of Mexico. Rising gasoline prices,
which reached $3 per gallon, shocked consumers. The oil companies brought
much disfavor upon themselves by announcing record profits afterward.
By May 2005 outstanding home mortgages in the United States totaled $7
trillion. About 25 percent of those mortgages were adjustable rate. Sales of
existing homes set another record in June 2005. The Economist made a dire,
but prescient, warning that, after the real estate bubble burst, it would wreck the
economy. Greenspan also warned that investors were unrealistically assuming
that the economy was permanently less risky. He noted that consumers were bor-
rowing against their home equity to increase their spending by $600 billion.
The Fed made its tenth straight interest rate increase in August. The Fed
fund rate was then 3.5 percent, a 2.5-percentage-point increase over the level of
the previous year. The Fed raised rates once again on September 20, 2005. By
then its assault on the real estate market seemed to have an effect. Economists
estimated that the dollar value of mortgages to be issued in 2005 would be
only $2.78 trillion, down from $4 trillion in 2003. By September, it was clear
that the housing market was slowing. At this point, the Fed began hinting that
it might slow its interest rate increases.
The savings rate for Americans turned negative in 2005 for the first time
since 1933, and savings rates divided along racial lines. A survey found that
African Americans were leaving the stock market. Their participation in
the stock market had risen from 57 percent in 1998 to 74 percent in 2002,
but declined to 57 percent by 2007. In contrast, 76 percent of whites were
invested in the stock market. African Americans saved about 50 percent less
than their white counterparts—$48,000 versus $100,000. Retirement account
figures were also troubling, with average savings of $73,000 for blacks versus
$210,000 for whites. Whites saved on average $260 per month while blacks
saved $180.

There was some good news. Consumer debt shrank in November for the
second straight month. Household wealth in the United States also reached a
new record level in the fourth quarter of 2005. However, that was due largely
to increases in home prices. The increase in value created a “wealth effect”
in the economy, meaning that increasing home prices made homeowners feel
wealthier—and that feeling encouraged their spending. The year 2005 was
the first year since the Great Depression that Americans spent more than they
earned.
Eastman Kodak lost $52 million in the fourth quarter of 2005. The company
reported an even bigger loss in the first quarter of 2006—$298 million. General
Motors sustained a loss of $8.6 billion in 2005. It was also having accounting
problems, and the company’s CEO apologized to shareholders for those failures.
GM announced in March 2006 that it was offering a buyout of union employ-
ees. The value of the buyouts ranged from $35,000 to $140,000. Ford Motor
Company reported a $1.19 billion loss in the first quarter of 2006. However,
ExxonMobil had a world-record profit of $10.71 billion in that quarter.
The trade deficit grew by 17.5 percent in 2005 to a record $725.75 billion,
and fourth-quarter growth in 2005 slowed to 3 percent on an annualized basis.
Housing construction also slowed, declining by 8.9 percent in December, and
building permits fell by 4.4 percent. Pending home sales slowed, the number
of new home sales fell by 5 percent, and sales of existing homes shrank by
5.7 percent in December. Residential renovations also slowed as a result of
increased interest rates. More ominously, housing inventories were at their
highest level in ten years. Although jobless claims were at the lowest rate in
six years, that happy situation would change dramatically in future months.
Banks continued to expand their business. Regulators allowed the Bank of
America and PNC to build hotel and office properties, further exposing them to
the vagaries of the real estate markets. Nevertheless, the banks had some good
results to show for the fourth quarter of 2005. Citigroup posted a 30 percent
gain, mostly as the result of a sale of an asset management group. Charles
Prince, the Citigroup CEO, was rewarded with the additional title of chairman
in anticipation of the retirement of Sandy Weil. UBS earnings tripled, but they
too were boosted by a sale of assets. Wachovia, Wells Fargo, US Bancorp, and
Fifth Third Bancorp all reported increased earnings. However, Bank of America
reported its first loss since 2001, as the result of trading losses and increased
consumer bankruptcies. Barclays’s net rose by 5.9 percent, but it announced
that its bad debt charges had increased by 44 percent. On an unrelated note,
Bill Miller at Legg Mason Value Trust Fund beat the S&P 500 for the fifteenth
straight year in 2005, but that streak was about to end.
More Interest Rate Increases
As 2006 began, the Wall Street Journal predicted that, despite a softening of
the housing market, the economy should continue to grow. In the first two

weeks of January the bond market thrived with issues valued at some $50
billion. The Fed signaled that it was less concerned about inflation, which
gave rise to a rally in the stock market. On January 6, 2006, the S&P 500
index was at a four-and-a-half-year high. The Dow Jones Industrial Average
closed above 11000 on January 9, 2006, for the first time since June 2001. The
market showed some volatility. The Dow dropped to 10667.39 on January 20
as a result of concerns over relations with Iran and energy prices, which were
rising. Oil prices were high, but financial analysts predicted that crude oil
would stabilize at about $60 per barrel. However, some contrarians forecast
that prices could go as high as $100 per barrel. By February 2006 crude oil
was trading in the range of $65 per barrel. The unemployment rate was at 4.7
percent, and retail sales jumped sharply in that month. Personal income and
spending both increased during January, and auto sales were up.
The NASDAQ market reached a five-year high on March 29, 2006. The
Dow reached a six-year high on April 20, 2006, climbing to 11342.89. Public
companies bought their own stock in record amounts. In the one-year period
ending March 31, 2006, such purchases totaled $367 billion, enough to pay for
the Medicare budget. Those purchases were useful in boosting per share income
and causing a rise in the company’s stock to the benefit of those executives
holding stock options. Housing starts jumped by 14.5 percent in January 2006,
but that was considered a seasonal aberration, as was an increase in existing
home sales in February. More telling, sales of new homes fell by 10.5 percent
in February. That was the largest decline in new home sales in nine years.
One large builder, Toll Brothers, reported a 29 percent drop in new orders,
and its home inventories were increasing. Another national home builder, KB
Homes, which had been in the business for more than fifty years, reported a
sharp increase in order cancellations and a decline in new orders.
A report published in February 2006 criticized Fannie Mae for falling short
of its subprime lending targets. However, subprime lenders like Countrywide
Financial Group, one of the largest subprime lenders, were experiencing a
sharp decline in loan applications as interest rates rose. As one Countrywide
employee put it: “We knew that showing a compellingly low rate was the most
powerful motivator for a prospect to respond. Duh,” and when interest rates
increased “we saw all call volume precipitously drop.”11 Nevertheless, more
than 20 percent of residential mortgages written in 2006 were subprime. As
a Fed official testified before Congress in March 2007, “the subprime sector
grew rapidly over the past three years and accounted for an outsized share of
originations in 2006. The roots of this increase can be traced back to the low
levels of market interest rates that existed in the early part of this decade which,
in turn, spurred significant volumes of mortgage refinancing, as well as new
originations.”12 The originations in 2006 were garnered in many instances by
reduced credit quality.
The Fed’s longest-serving chairman, Greenspan announced in October 2005
that he was leaving at the end of his term in January 2006, which he did. After

a reign lasting for eighteen years under four presidents, he retired at the top of
his game, achieving legendary status as Fed chairman and reverential treatment
by much of the world as the leading guru on financial matters. In retirement,
Greenspan became a pundit on all matters economic. Even though he was a
Republican, Greenspan’s autobiography attacked the deficit spending of the
George W. Bush administration, drawing headlines in the press. However, the
subprime crisis shattered Greenspan’s reputation, as he was blamed for not
curtailing the housing market before it turned into a bubble.
Changing of the Guard
Ben Bernanke succeeded Greenspan as the Fed chairman on February 1,

2006. He was an economics professor from Princeton University, where he
had displayed an intense interest in the economics of the Great Depression,
background that would prove useful during his tenure at the Fed. Bernanke
had previously served on the Fed’s Board of Governors. At the time of his ap-
pointment to the Fed, Bernanke was serving as the chairman of the president’s
Council of Economic Advisers.
Greenspan used his last meeting at the Fed to raise interest rates once again.
It was then clear that the Greenspan interest rate increases crippled the real
estate market, but his successor would have to finish the job. The hope that it
would be “one and done” for Bernanke, meaning that he would raise interest
rates one more time and then pause, was not realized.13 Bernanke continued
Greenspan’s attack on the real estate market with three more consecutive
interest rate increases.
The Wall Street Journal published a front-page report in the first week of
March 2006 describing how the property management business was gearing
up for an increase in home foreclosures. That newspaper warned on March
11 that homeowners faced higher mortgage payments as the low rates in their
adjustable mortgages reset. Home-equity borrowing also slowed with the rise
in interest rates. Bernanke shrugged off those concerns, but warned Congress
on March 14 that federal budget deficits were too large and should be reduced.
The budget deficit was declining in 2006 but was expected to expand in 2007
and would explode in the wake of the subprime crisis.
Bernanke also opined in March that short-term rates might have to be held
to a lower level if a glut of long-term savings pushed down long-term rates
any further. Undeterred by the increasingly alarming signals that the housing
market was broken, Bernanke announced another rate increase on March 28,
2006, pushing short-term rates to 4.75 percent.
First-Quarter Results
First-quarter results for financial firms were strong. Lehman Brothers re-
ported record results. Profits at Bear Stearns rose by 36 percent, and those for

Morgan Stanley were up 17 percent. Citigroup, Wachovia, and Wells Fargo

all had good results. Citigroup had other purportedly good news. Corporate
governance firms publicly announced in March that it had improved its regula-
tory controls. The Fed also allowed Citigroup to renew acquisitions in April
2006, removing a restriction that it had imposed as a result of Citigroup’s
involvement in the Enron-era scandals. Bank of America’s profits were up 14
percent, and JPMorgan’s net income rose by 36 percent. SunTrust reported
higher profits, but warned that it would face problems in its loan portfolio in
the future. Washington Mutual (WaMu) had a good quarter, and it purchased
Commercial Capital for $983 million in April 2006.
S&P 500 companies bought more than $100 billion of their own stock in
the first quarter of 2006. Corporate profits were up overall, but auto sales were
dropping. Office vacancies were at their lowest level in five years. Payrolls
jumped sharply in March. Existing home sales increased in that month, and
consumer confidence was at a four-year high. Although home prices increased
by only 2 percent on an annual basis in March, the slowest rate of growth in
two years, the U.S. economy grew at an annual rate of 4.8 percent in the first
quarter.
This largely rosy picture carried over into April, as retail sales rose. Tax
receipts were up by 13.5 percent, mostly as a result of increased tax payments
by the wealthy. However, the auto industry was clearly in a slump. GM sales
dropped by more than 10 percent in April 2006. There was other uncertainty
in the air. Gold prices rose to more than $600 per ounce in April, and crude
oil traded at $70 per barrel. Florida home sales were noticeably cooling, and
foreclosures around the country were increasing.
The Dow Jones Industrial Average hit a six-year high on May 2, 2006,
reaching 11416.45. Gold traded at $700 per ounce on May 10, 2006. The Dow
closed at 11639.77 that day. Brokerage firm stock prices were rising rapidly,
and insiders were cashing in on that upswing, which, in retrospect, turned out
to be a provident thing for them.
Paulson Arrives
The Bush administration allowed the dollar to decline in value against the euro
and other currencies in the hope that this would make U.S. products cheaper
abroad and thereby help shrink a ballooning trade deficit. That strategy was
not immediately successful. The Fed made its fifteenth straight interest rate
increase in March, and Bernanke suggested that more would be forthcoming.
However, in mid-April the Fed signaled that it was considering a pause on
further interest rate increases. Nevertheless, a sixteenth straight rate increase
was announced on May 10, 2006, pushing short-term rates to 5 percent.
Minutes from the Fed meeting on May 10 showed some uncertainty over
how long the rate increases should continue. Fed members seemed to be bal-
anced between a pause and further increases. Bernanke then signaled that the

Fed might pause in increasing rates, but that statement turned out to be a head
fake. Because of continuing concerns over inflation, the Fed raised interest
rates for the seventeenth consecutive time on June 29, 2006, pushing short-
term rates to 5.25 percent. By then, short-term interest rates were higher than
long-term rates. This was troubling, since an analysis by the Federal Reserve
Bank of San Francisco in 2003 had found that all of the previous six recessions
were preceded by an inverted yield curve.
Bernanke discounted the possibility that the interest rate inversion signaled
a recession because both long- and short-term rates were relatively lower than
had been the case in prior recessions. An inverted or flat yield curve posed other
concerns because it would place stress on institutions that borrowed short term
and lent long term in “carry trades.” Compounding the situation was the return
to the market of the thirty-year “long” Treasury bond in February 2006.
In May 2006, President Bush appointed Henry M. Paulson, Jr., to serve as
his treasury secretary, succeeding John Snow. Paulson had been the CEO and
chairman of Goldman Sachs, where political correctness on splitting those two
roles did not reign.14 Lloyd Blankfein followed Paulson as Goldman’s CEO
and chairman. Blankfein would play a prominent role during the subprime
crisis. Paulson was paid $29.8 million at Goldman in 2004, but his personal
fortune from Goldman stock was rumored to be as much as $700 million. As
a result of government conflict of interest rules, Paulson sold his remaining
Goldman stock at $485 million for $142 per share when he became secretary.
Government regulations provided a tax break for such sales, saving Paulson
some $100 million in taxes.
Paulson had been an All-Ivy, All-East linemen at Dartmouth and was a
graduate of the Harvard Business School. He served on the White House
Domestic Council and as a staff assistant to President Richard Nixon. He had
also served at the Defense Department as a staff assistant. Paulson worked his
way up through the ranks at Goldman Sachs and played a key role in ousting
NYSE head Richard Grasso, turning that institution into a mostly electronic
market.
Interest Rate Effects
The subprime market, which was boiling in 2005, continued to percolate in

2006, centered in California. More than 600,000 subprime loans were origi-
nated in that state in each of those years, nearly 25 percent of all subprime
originations during that period. Delinquency rates rose in May 2006 for home
mortgages issued a year earlier, a harbinger of a decline in credit quality.
However, housing starts rose 5 percent in May over those in April.
Home prices rose by 1.17 percent in the second quarter of 2006, but hous-
ing inventories hit a nine-year high in June, and pending new home sales
dropped in both June and July. The overall economy was still strong, with an
unemployment rate in June 2006 of only 4.6 percent. However, a consensus

of economists expressed concern that the Fed would raise rates too much and
send the country into a recession. Inflation concerns remained, due in part
to crude oil prices, which exceeded $72 per barrel in the first week of June.
Wheat and corn prices were also up. Wages were rising, but payroll growth
had slowed.
Toll Brothers orders for residential housing fell by 47 percent in the sec-
ond quarter, and it reported a 19 percent decline in earnings. Fannie Mae had
some good news: The Justice Department concluded a criminal investigation
of its accounting manipulations without filing charges. However, the Bush
administration sought, unsuccessfully, greater regulation for both Fannie Mae
and Freddie Mac.
Large public companies bought $116 billion of their own shares in the second
quarter. Overall corporate profits were up in that quarter by 3.2 percent over
the previous quarter and 20.5 percent over the previous year. Investment and
commercial banks had a banner quarter: Bank of America posted an 18 percent
increase in net income, JPMorgan Chase tripled its earnings, Lehman Broth-
ers’ earnings increased by 47 percent, Goldman Sachs and Morgan Stanley
doubled their earnings, and Bear Stearns had a record profit of $539 million.
Citigroup’s net was up 3.8 percent, with profits of $5.27 billion, but it was
struggling and was pushed out of its position as the world’s largest bank by
HSBC. Citigroup CEO Charles Prince rejected a cost-cutting program even
though such discipline was needed to boost the bank’s lagging share price.
The amalgamation of financial services at Citigroup had proved a regulatory
disaster for the bank. Starting with Enron and the financial analyst scandals,
and before plunging into the subprime crisis, Citigroup had been forced to
pay billions of dollars in fines and settlements.
Third Quarter
In the second week of July 2006 the stock market began experiencing volatil-
ity, attributed to confusion over the Fed’s interest rate policies and outlook on
inflation. On July 19, Fed chairman Bernanke stated that an ongoing economic
slowdown should cool inflation and cause the stock market to rise. This was
perceived as a signal that the Fed would slow its interest rate increases. By
August, ten of the twelve federal reserve banks were opposed to any further
interest rate increases.
Inflation was still a concern, but later evidence revealed that the rate of
inflation was slowing. Hiring weakened in July, but retail sales were strong.
Consumer spending rose that month, but housing starts were down almost
20 percent over the same period the previous year. Sales of existing houses
fell by 11.2 percent in July. Sales of new homes were also down. Housing
inventories rose by 4.7 percent in August, and the number of existing home
sales declined again in August. Median home prices also fell for the first
time since 1995.

Japan raised its discount rate from 0.00 percent to 0.25 percent, which
seemed to signal a recovery in that country after a decades-long recession. The
European Central Bank (ECB) and the Bank of England also raised interest
rates 0.25 percent in August. However, the Fed left rates unchanged in a close
vote among the governors at its meeting on August 8, 2006. This was its first
pause in raising interest rates in over two years.
The First Cracks Appear
The Dow Rises
The Fed left interest rates alone once again at its meeting on September 20,
2006. Short-term rates remained at 5.25 percent. The jobless rate fell to 4.4
percent in September 2006. On October 3, the Dow Jones Industrial Average
set a new record, at 11727.34. Bank regulators tightened restrictions on low-
down-payment mortgages in September. Those mortgages resulted in increased
costs to the borrower at later periods of repayment.
Bernanke finally seemed to awaken to the problems in the housing market
in the first week of October 2006, when he warned that declines in that market
could affect overall growth. Economic signals were inconsistent, however.
The budget deficit narrowed in October, and the Dow closed above 12000 on
October 19, 2006. JPMorgan reported that its net rose by 30 percent in the third
quarter. However, WaMu, the giant mortgage lender, had a 9 percent decline
in earnings in that quarter, while Citigroup had a 23 percent drop. Citigroup
issued a profit warning on October 1 related to writedowns for securities backed
by subprime mortgages and loans tied to corporate takeovers. UBS, the largest
bank in Europe, also warned of an unexpected loss in the third quarter because
of a $3.42 billion writedown on mortgage-backed securities.
Still concerned with inflation, Bernanke held interest rates steady at 5.25
percent at the Fed’s October 25, 2006, meeting. The Fed also announced that
it was placing a stronger focus on the housing market, predicting a severe
slowdown in that sector. Even so, it seemed tone-deaf to the possibility of a
severe crisis approaching. Construction slowed by 14.6 percent in October.
Home sales fell by 3.2 percent over the previous month, 25.4 percent lower
year on year. Toll Brothers experienced a 56 percent drop in orders in the third
quarter of 2006, and completed sales declined by 10 percent.
A Wall Street Journal survey of economists in November 2006 produced
a consensus estimate that, while the worst of the housing slump had passed,
housing prices would continue to decline. This seemed to refocus the Fed
on inflation. Bernanke announced on November 28, 2006, that inflation was
“uncomfortably high” and that the Fed’s bias was to raise, rather than lower,
interest rates. As it turned out, the Fed’s concerns over inflation were inflated,
and that concern stopped it from taking the drastic action needed to halt the
slide in the housing market.

False Hopes
New home sales rose by 3.4 percent in November, and existing home sales
increased, leading to further predictions that the housing slump was over.
Mortgage applications increased between August and December 2006, but the
number of listings for homes in eighteen major metropolitan areas declined
in December. Although delinquencies on subprime loans were at their highest
level in ten years as December 2006 began, a Wall Street Journal survey of
economists concluded that those delinquencies should cause no significant
damage to the financial structure. The Fed rejected rising demands for an
interest rate cut, announcing that the economy was in better shape than it had
been in 2002, when it began slashing rates. The Fed decided to leave rates
as they were at its meeting on December 12, 2006, stating that it was still
concerned with inflation.
Some institutions tried to reduce their exposure to the mortgage market.
ABN Amro hired Lehman Brothers to sell its mortgage lending assets. The
severity of the downturn in the market was becoming more apparent. Two
subprime lenders failed in December, and KB Homes announced an asset
write-off of as much as $285 million that month. Adding to KB Homes’
problems was an investigation by the Securities and Exchange Commission
(SEC) over options backdating.
Profits at financial institutions were good for all of 2006. Goldman Sachs
set a Wall Street record after its net for the year rose by 93 percent. Bear
Stearns’s profits rose 38 percent for the year. Lehman Brothers’ profits were
up 22 percent. Its CEO, Richard Fuld, was given a ten-year compensation
package valued at $186 million in company stock. The firm’s top three execu-
tives made $92.3 million in 2006. Both Lehman Brothers and Bear Stearns
would fail during the subprime crisis. Bank of America had a good year, and
its CEO, Kenneth Lewis, was paid $27.9 million plus $77 million in stock
options. At the time it would have been hard to imagine that the bank would
be facing failure during the impending subprime crisis and that Lewis would
become a widely reviled executive.
Revenues at Citigroup for the fourth quarter of 2006 set a record, up 15 percent
to $23.8 billion. It bought back $1 billion worth of stock in the fourth quarter
and $7 billion for the full year and paid out $9.8 billion in dividends as well as
announcing a 10 percent increase in dividends after its fourth-quarter results
were posted, though these turned out to be false profits. American International
Group (AIG), the world’s largest insurance company, posted fourth-quarter
earnings nearly eight times higher than those for the previous year. AIG then
announced plans to repurchase $5 billion of its common shares during 2007 and
to increase its dividend by 20 percent. AIG profits were up a spectacular 700
percent in 2006 over the previous year. Nothing indicted that AIG would have to
be rescued by the federal government when the subprime crisis peaked because
of concern that its failure would undermine the entire U.S. economy.

In December 2006, Fannie Mae restated its earnings, cutting them by $6.3
billion, and its income fell 36 percent over the previous year. Freddie Mac
reported an earnings increase of 3.8 percent in 2006 compared with 2005. A
Wall Street Journal article asserted that it could profit from the burgeoning
turmoil in the subprime markets. Actually, both Fannie Mae and Freddie Mac
would fail as a result of their subprime exposures.
Goldman Sachs had been a major underwriter of subprime mortgage securi-
ties, but in December 2006, its CFO, David Viniar, pushed the firm toward a
negative position on those securities. Viniar ordered Goldman traders to sell
10 percent of their positions, which were somewhat illiquid, in order to value
them for the purpose of hedging their risks. He also had the firm cancel fur-
ther underwritings, sell inventory, and go short on subprime securities. Those
acts saved Goldman Sachs from massive losses, or worse, in the subprime
crisis.15
Existing home sales dropped by 8.4 percent during 2006, the worst record
in seventeen years. However, average income in United States grew in 2006
for the first time in six years. Average adjusted gross income was then just over
$58,000. The average tax rate of the richest 1 percent of Americans in 2006
declined, and that group increased its share of adjusted gross income.
The New Year—2007
Mixed Signals
Yet another survey of economists by the Wall Street Journal, this time on Janu-
ary 2, 2007, found a consensus that the United States was about to shake off the
ongoing housing slump. Treasury Secretary Paulson stated a few weeks later
that the housing market appeared to have stabilized. Although minutes from
the previous Fed meeting expressed doubt about the strength of the economy,
a Fed official stated that inflation remained a concern and that no rate cuts
should be expected. The Fed was then in the midst of a debate over whether it
should have a “hard” or a “soft” inflation target. At its next meeting, on Janu-
ary 31, 2007, it decided to leave rates unchanged, at 5.25 percent. There was,
however, good news on the inflation front. Crude oil prices declined to $56.31
a barrel on January 5, 2007, and to $50.48 a few days later. Oil consumption
actually slowed in developed countries during 2006.
The bond market signaled concern over subprime defaults, and it was
right to do so. Mortgage lender share prices were falling rapidly as subprime
mortgage defaults increased. The market value of the seven biggest mortgage
lenders fell by $3.7 billion. The Independent National Mortgage Corporation,
universally known as IndyMac, the largest savings and loan association in
the Los Angeles area and seventh-largest mortgage originator in the United
States, issued a profit warning in January 2007. Centex, a home builder, also
issued a profit warning. Toll Brothers, the giant luxury home builder, saw its

orders shrink by 33 percent in January 2007, and it experienced a 67 percent

decline in profits.
Mortgage delinquencies rose to a five-year high in January 2007. Hous-
ing starts fell 14.3 percent in January over those in December 2006. Defaults
on piggyback mortgages—which allowed the borrower to borrow the down
payment for the house—had increased, and some lenders curbed their offer-
ings for such loans. Commercial banks and investment bankers dumped their
mortgage investments as delinquencies continued to increase. However, bank
reserves for bad loans were at the lowest level since 1990.
Zions Banccorporation, which operated in several Western states, purchased
$840 million in off-balance-sheet investments held by an affiliate, an action
necessitated by a “liquidity agreement” requiring Zions to purchase those se-
curities if they became nonperforming. The securities were mortgage-backed
and appeared to be part of an asset-backed commercial paper (ABCP) program.
The affiliate was unable to raise money in the commercial paper market to
support those investments.
The Dow Jones Industrial Average closed at a record of 12741.86 on Febru-
ary 14, 2007, but the dollar continued to weaken. The stock market also took
a hit in the last week of February 2007, when vacant homes for sale reached
a forty-year high, at 2.7 percent of all homes. Freddie Mac announced at the
end of February that it was curbing its subprime purchases. HSBC Holdings
disclosed that it was reserving $1.76 billion for bad debts associated with
subprime mortgage lending, much more than HSBC’s original estimates. The
report heightened concerns over the subprime market. The U.S. mortgage unit
of HSBC experienced a 5.26 percent delinquency rate for the first quarter of
2007 and subsequently appointed a new head for its U.S. subprime business.
Share prices for subprime lenders continued to drop sharply. H&R Block was
among those facing large losses from subprime loans. Bank and other regula-
tors began to crack down on loose subprime lending practices. Among others,
Beazer Homes was under investigation for its mortgage lending practices. John
Paulson, a hedge fund manager, doubled the value of $1 billion in investments
that shorted the subprime market in the first quarter. That bet would become
the basis for a sensational suit brought by the government against Goldman
Sachs that is described in Chapter 7.
New Century Financial
New Century Financial Corporation, headquartered in Irvine, California, faced

bankruptcy in March 2007. The nation’s second-largest subprime mortgage
lender, it was experiencing a large number of defaults. Its lenders cut off further
funding, and the company filed for bankruptcy in April 2007. New Century was
also under criminal investigation. The company originated over $56 billion in
mortgages in 2005 alone. After its failure, Ellington, a hedge fund, purchased
New Century’s mortgage portfolio for a mere $58 million.

The New York Times accused New Century’s auditor, KPMG, of failing to
detect the company’s problems before the bankruptcy. The State of California
audited New Century in August 2006 and found no problems, even though the
company declared bankruptcy just seven months later. An “independent” report
on KPMG’s role as auditor of New Century was commissioned in connection
with the firm’s bankruptcy proceedings and was made public in March 2008.
The conclusions in the report were predictable because the “independent”
examiner preparing the report was Michael J. Missal, formerly an attorney
in the SEC’s enforcement division, who had been involved in the WorldCom
investigation. Missal compared KPMG’s auditing practices with those of
Arthur Andersen in the Enron debacle.
A bankruptcy examiner also charged that KPMG had aided New Century in
manipulating its accounts, and the examiner urged investors to sue the accounting
firm. New Century’s trustee did sue KPMG in April 2009. The trustee claimed
that the accounting firm had been grossly negligent in its audit and that a super-
vising partner had rejected warnings from a subordinate regarding the fact that
New Century was not properly accounting for its operations. By then, accounting
manipulations were so common as to be unremarkable, and the scandal was not
heavily covered in the press. In December 2009, over two and a half years after
the company became bankrupt, the SEC filed suit against New Century and three
of its executives. The SEC charged that the defendants had publicly touted New
Century’s “responsible” lending practices, which were actually irresponsible, and
claimed that the company was outperforming its peers. However, the defendants
had received dire warnings in September 2006, through internal “Storm Watch”
reports, that New Century’s mortgage portfolio was deteriorating sharply in value.
The defendants were also charged with overstating the company’s revenues.
Morgan Stanley agreed to pay the State of Massachusetts $102 million to settle
charges that it loaned money to New Century that was used to provide mortgages
to unqualified borrowers. Morgan Stanley then securitized those loans and sold
them to investors who sustained significant losses.
More Losses
The inventory of foreclosed homes grew, and banks tightened their lending
standards for subprime loans. On March 22, 2007, KB Homes announced an
84 percent decline in earnings. Countrywide Financial Group and IndyMac
also suffered sharp declines in their first-quarter earnings. Washington Mutual
had a first-quarter decrease in earnings of 20 percent as a result of subprime
losses. Home Depot’s net income dropped 30 percent in the quarter, attributed
to the slumping housing market.
Citigroup, already under criticism for a drop in profits due to higher expens-
es, appeared to have growing problems. The firm’s first-quarter earnings fell
11 percent as the result of a $1 billion charge to cover a massive, but belated,
restructuring that sought to cut costs and increase earnings. The restructuring

included the elimination of 17,000 jobs. Edward Lampert’s hedge fund bought
a cumulative $800 million in Citigroup stock, possibly signaling an attack on
management, but it turned into a very bad investment.
Wells Fargo’s net was up 11 percent for the quarter. JPMorgan was up 55
percent, while Bank of America experienced a much more modest increase
of 5.4 percent. Lehman Brothers’ profits rose 27 percent, but that firm an-
nounced that it was issuing $3 billion of preferred shares in order to shore
up its capital position. That announcement seemed out of line with Lehman’s
profit reports, and turned out to be a first warning that Lehman might have
some large exposures on its books.
Global mergers in the first quarter of 2007 were valued at $1.1 trillion, a
record, of which mergers and acquisitions in the United States comprised $439
billion. The unemployment rate fell to 4.4 percent in March, the lowest level in
six years. Personal income was also up, but the housing market continued its
slump. Existing home sales shrank 8.4 percent in March, the largest monthly
decline since 1989. In April, new building permits dropped to their lowest level
in almost ten years. Productivity, manufacturing, and service-sector growth
weakened. The U.S. economy grew at an annual rate of only 1.3 percent in
the first quarter, the lowest rate in four years.
The Fed reported on March 5, 2007, that liquidity was not in short supply,
but its earlier interest rate changes laid the groundwork for another financial
crisis. Home sales and new residential construction had slowed dramatically,
and the housing market became glutted with unsold homes. Toll Brothers
continued to cut back its construction programs, as that company experienced
its worst slump in forty years. Toll Brothers announced a first-quarter drop in
revenue of 19 percent and a reduction in orders of 24 percent.
At its meeting on March 21, 2007, the Fed left the Fed fund rate unchanged.
Bernanke was increasingly criticized for placing too much emphasis on infla-
tion expectations. The Fed shrugged off those critics; citing concern over infla-
tion, it indicated that another rate increase might be in order in future months.
A Fed official again warned of inflation risks in April. A survey of economists
in March 2007 reflected a consensus view that despite subprime concerns no
recession would develop. Another study undertaken in March forecast that 1.1
million foreclosures would occur over the next year as a result of ARM resets,
but predicted that this would not damage the economy.
On to the Second Quarter
The Dow Jones Industrial Average set a new record on April 4, 2007, and
exceeded 13000 for the first time on April 26, 2007. But bad news continued
to trickle out. Same-store sales (those that had been in operation for at least
one year) were falling. Wal-Mart had its steepest-ever decline in such sales.
Consumer spending also declined. New home sales increased in April 2007
because of discounts, but existing home sales declined, and inventory was at

a fifteen-year high. KB Homes reported a $148.7 million loss in the second

quarter.
Speculators holding properties found that they could no longer flip them for
an assured profit, as had been the case while the housing market bubble was
growing. In Naples, Florida, one of the hottest markets during the boom, one
speculator tried to sell her portfolio of properties through an auction held at
a local hotel, without much success. The number of foreclosures hit a record
high in Collier County, Florida, which included Naples and its environs. The
nearby Ft. Myers/Cape Coral area had the highest rate of mortgage foreclosures
in the country as the second quarter of 2007 began, reaching 24.1 percent. The
New York City area had an 11.6 percent foreclosure rate for subprime mort-
gages. Another national leader in the number of foreclosures was Stockton,
California, where one in seventy-five homes was in foreclosure.
“Short” sales, in which a foreclosed home is sold for less than the amount of
its outstanding mortgage, became common as homeowners found themselves
unable to meet their payments due to the rising interest rates. The slump spread
to condominiums and private residences that had been bought by speculators
in anticipation of rising prices. Many speculators who bought preconstruction
units sought to renegotiate with builders in order to avoid their purchase price
obligations, which were at prices well above the present market value of the
property under contract.
Moody’s downgraded more than 30 highly rated subprime offerings in May
2007 and subsequently another 131 downgrades in June. This raised a con-
cern as to why so many highly rated securities were downgraded so quickly.
Had they been correctly rated in the first place? Whatever the answer to those
questions, this was only the beginning of a mass of downgrades for subprime-
related securitizations.
ACC Capital Holding (ACCH), a California institution that created one of
the largest subprime lenders, was in trouble and would fail. Roland Arnall,
the founder of ACCH, became U.S. ambassador to the Netherlands under the
administration of George W. Bush. His family had escaped the Holocaust dur-
ing World War II and immigrated to the United States, where Arnall began his
career selling flowers on the street. Arnall founded the Long Beach Savings
& Loan in 1979, which entered the business of selling subprime mortgages
to Wall Street investment banks in the 1990s for securitization. Long Beach
surrendered its federal S&L charter in 1994 to become a private mortgage
lender.
In 1997, Long Beach split itself into Ameriquest Mortgage Company, a
private company owned by ACCH, and a publicly traded subsidiary, Long
Beach Mortgage Company. The latter was bought by Washington Mutual in
1999 and became the basis for Washington Mutual’s subprime operations.
ACCH owned Argent Mortgage in addition to Ameriquest, one of the na-
tion’s largest subprime lenders. Ameriquest spread its operations nationwide
through television advertisements that featured the slogan: “Proud Sponsor of

the American Dream.” Like Enron, Ameriquest had a baseball stadium named
after itself—the Texas Rangers stadium—and even sponsored the halftime
show at the Super Bowl in 2005. The firm was also somewhat infamous for
the $325 million it paid to settle predatory lending charges.
Ameriquest was among the first of the subprime lenders to experience the
effects of the downturn in the subprime mortgage market. It announced in
May 2006 that it was cutting 3,800 jobs and closing its 229 branch offices as
a result of the downturn in real estate sales and increased interest rates. On
September 10, 2007, Ameriquest stopped making loans entirely. To its regret,
Citigroup bought what was left of ACCH’s assets, renaming those operations
Citi Residential Lending, a company that lasted only a few months before it
was shut down with significant losses.
The Fed left interest rates unchanged at 5.25 percent at its meeting on May
9, 2007, and again expressed concern over inflation. It seemed oblivious to the
effects of rising interest rates on the housing market and perhaps was blinded
by other favorable data. Consumer confidence was up despite the housing
slump. The number of new jobs added in May doubled over that in the previous
month. Still, news from the housing sector continued to be negative. Housing
starts fell by 24.2 percent in May over a year earlier. The number of houses
for sale rose 5 percent, and new home sales declined by 1.6 percent over the
level in April. Housing prices fell once again in the second quarter. The next
month was no better. New home listings rose in June 2007, while existing
home sales fell by 3.8 percent.
The economy grew at an annual rate of 4 percent in the second quarter of
2007, and the Fed reported that the economy was stronger than it looked. The
stock market dropped after Bernanke stated on June 5, 2007, that he was still
worried about inflation. He warned, incorrectly as it turned out, that the bur-
geoning problems in the subprime market were unlikely to spill over into the
broader economy or the financial system. Unemployment was still a low 4.5
percent in June 2007, and retail sales were up. The Fed left rates unchanged
at its meeting on June 28, 2007, and appeared to reject any rate cuts in the
immediate future. Yields on five-year Treasury securities reached a five-year
high in June 2007.
Some investment banks had a banner second quarter. JPMorgan’s net rose
by 20 percent, Bank of America experienced a 5.2 percent rise, Citigroup
was up 18 percent, and Morgan Stanley announced a 40 percent increase in
profits for the second quarter. UBS reshuffled its management as it warned of
large losses. IndyMac experienced a 51 percent decline in earnings. Although
economists predicted that the housing slump would continue at least until the
end of the year, IndyMac optimistically hired more than 600 employees in
order to increase its mortgage lending.
Despite a loss by Freddie Mac of $211 million in the second quarter, Fan-
nie Mae and Freddie Mac announced the creation of a program for delinquent
subprime borrowers that would allow them to avoid foreclosures. Oblivious

to the gathering storm, these government-sponsored enterprises (GSEs) also

stated that they would be buying billions of dollars in prime loans in order to
support the mortgage market.
James B. Lockhart III, director of the Office of Federal Housing Enterprise
Oversight (OFHEO), which was responsible for the safety and soundness of
Fannie Mae and Freddie Mac, classified them as adequately capitalized as of
June 30, 2007. However, OFHEO also reported that Fannie Mae and Fred-
die Mac’s risk controls were still inadequate and that a number of safety and
soundness issues were not yet resolved. In addition, Fannie Mae was not yet
current in filing its financial reports, and significant work remained before
Freddie Mac could become a timely filer of financial statements. Although
OFHEO appeared to be a most gentle regulator, Freddie Mac president Eugene
McQuade turned down the post of CEO at that GSE because of what he called
onerous regulatory oversight.
Other regulators seemed to be awakening to the fact that the subprime
mortgage market might be in a meltdown and issued guidelines for strength-
ening subprime underwriting standards. The Office of Thrift Supervision
also explored the possibility of imposing restrictions on predatory lending
practices.
Bear Stearns—The Struggle Begins
Bear Stearns was a Wall Street icon, known for its aggressive trading and
investment bank activities. Joseph Bear, Robert Stearns, and Harold Mayer
founded the firm as a partnership in 1923. Bear Stearns initially dealt in equi-
ties but soon expanded into government securities. The firm prospered in the
1920s and was able to survive the Great Depression without discharging any
employees. It survived by selling New Deal–era government bonds to banks
that had large amounts of accumulated cash and no safe place to put it.
Salim “Cy” Lewis was hired in 1933 to direct Bear Stearns’s institutional
bond business. Lewis became a partner five years later and rose to lead the firm
in the 1950s. His aggressive style established the culture of the firm, which
had a highly competitive culture of “PSDs”: “poor,” “smart” traders with a
“desire” to get rich. Another forceful leader arrived at the firm in the form of
Alan “Ace” Greenberg, who became chairman of Bear Stearns in 1978. Green-
berg started out at the firm as a clerk, and, true to the culture of Bear Stearns,
he became renowned for his aggressive trading style. Under Greenberg, Bear
Stearns grew rapidly and expanded its activities into nearly every niche of
investment banking, and it became a public company in 1985.
James E. Cayne succeeded Greenberg as CEO in 1993, but Greenberg
remained chairman until 2001. They guided the firm through some turbulent
years and through a scandal involving their clearing business for small broker-
dealers. One of its customers, A.R. Baron, a small broker-dealer, declared
bankruptcy in 1996 after defrauding its customers of $75 million. Courts had

generally ruled that clearing firms, such as Bear Stearns, were not respon-
sible for the fraud of introducing brokers, like Baron, for which they cleared.
However, the government charged that Bear Stearns had received numerous
warning signals of widespread fraud at Baron, and Bear Stearns agreed to pay
the SEC and the Justice Department $42 million to settle charges relating to
its clearing activities for that firm.
In another case, Bear Stearns was able to convince an appeals court to set
aside a $164 million jury award for damages claimed by a wealthy currency
trader, Henryk de Kwiatkowski. He had traded through an account at Bear
Stearns and made profits of over $200 million in 1994–95, before he made
a series of bad trades that resulted in net losses of $215 million. De Kwiat-
kowski claimed that Bear Stearns had provided bad advice, but the appeals
court ruled that he was a sophisticated trader and was responsible for his own
trading decisions.16
After the market slump at the beginning of this century, Bear Stearns laid off
about 7 percent of its staff. Jamie Dimon, the CEO at Bank One in Chicago,
sought to acquire Bear Stearns on favorable terms, but that offer was rejected.
Bear Stearns was looking for its own business opportunities and instead became
a large player in the prime brokerage business of servicing hedge funds by
providing them with financing, stock borrowing for short-selling operations,
and custody arrangements, as well as clearing their trades.
Bear Stearns was also an early participant in the subprime mortgage mar-
ket. It created EMC Mortgage in the 1990s to act as its own subprime lender.
Initially, that firm bought mortgages from the Resolution Trust Corporation,
the government entity that was selling off assets from failed S&Ls after the
crisis in that market in the 1980s. As that business tapered off in the mid-
1990s, ECM switched to subprime lending originations. Initially it used loan
brokers to originate the loans, but it later began purchasing subprime loans
from nonbank subprime mortgage originators.
Bear Stearns was an aggressive participant in this market. In 2008 Bear
Stearns and EMC agreed to pay $28 million to settle Federal Trade Commis-
sion (FTC) charges that they had engaged in unlawful practices in servicing
consumers’ home mortgage loans. Among other things, EMC was claimed to
have misrepresented the amounts that borrowers owed and to have charged
unauthorized fees, including late fees, property inspection fees, and loan
modification fees. The firms were also charged with engaging in abusive col-
lection practices.
EMC avoided the worst of the problems that arose during the first subprime
crisis in 1998–99. Bear Stearns not only remained in the market but began a
massive expansion of its role through securitizations of subprime loans. It also
acquired another subprime originator, Encore Credit, a rather strange invest-
ment to make because Encore had been selling to Bear Stearns mortgages of
low quality, many of which Bear Stearns returned. In all events, the mortgage
business at Bear Stearns reported massive profits in 2006. Bear Stearns’s profits

rose by 36 percent in the first quarter of 2006 and had a record profit of $539
million in the second quarter, with overall profits up by 38 percent year on
year. That happy situation changed with the subprime crisis.
Bear Stearns reported an 8 percent gain in revenues in the first quarter of
2007, but advised that earnings had been hurt by losses from subprime expo-
sures. In June 2007, Bear Stearns experienced severe problems with two of
its hedge funds invested in subprime loans. One of these hedge funds bought
highly rated long-term collateralized debt obligations (CDOs) that it funded
with short-term borrowings in the repurchase (repo) market, profiting from
the yield spreads. That fund was profitable for forty consecutive months, and
a second fund was created that used similar strategies.
Problems surfaced after some other hedge funds accused Bear Stearns of
manipulating the market for subprime loans. The net asset value of the two
Bear Stearns hedge funds fell by 23 percent shortly after those accusations
were made. The Bear Stearns hedge funds had liquidity problems and tried
to sell mortgage-backed instruments worth $4 billion. Those sales underlay
the claims that Bear Stearns was trying to manipulate the market in order to
increase the value of those instruments. Concerned that the Bear Stearns hedge
funds might default, Merrill Lynch grabbed $850 million of Bear Stearns assets
(subprime mortgages) that were being held to collateralize its credit obligations
to Merrill. In order to stop this run on the hedge funds’ assets, Bear Stearns
lent the hedge funds $3.2 billion on June 22, 2007. However, the hedge funds
continued to drop in value until they were virtually worthless.
On July 17, 2007, Bear Stearns reported that these hedge funds had expe-
rienced massive losses. The Bear Stearns High-Grade Structured Credit Fund
had lost more than 90 percent of its value, and the Bear Stearns High-Grade
Structured Credit Enhanced Leveraged Fund had lost nearly all of its investor
capital. Bear Stearns fired Richard Marin, the head of its money management
unit. The hedge fund assets remained illiquid. An effort to auction off their
mortgage-related assets by JPMorgan was canceled for lack of buyers. Bear
Stearns’s Alt-A mortgages (those just above the subprime grade) carried a
delinquency rate (i.e., those delinquent more than sixty days) of 15 percent,
while the industry average was a much smaller (although still quite significant)
8.4 percent. This disparity suggested a significant lack of quality control on
the part of Bear Stearns.
The Justice Department indicted two Bear Stearns hedge fund managers,
Matthew Tannin and Ralph Cioffi, charging that they had misrepresented their
personal investments in the hedge funds to investors in order to bolster inves-
tor confidence. Cioffi moved $2 million of the $6 million of his own funds
out of one of the hedge funds, without disclosing that fact to investors. He
was charged with insider trading as a result of that withdrawal. In an effort to
discourage an investor from withdrawing funds, Cioffi also told him that he
personally had $8 million invested in the fund. The indictment further charged
that the two men had told investors that the funds were invested in low-risk,

high-grade debt securities that were mostly AAA- or AA-rated tranches of

subprime and other mortgages. Investors were told that they could expect a
modest, safe, and steady source of returns with only slightly higher risk than
that of a money market fund. Actually, until the subprime crisis such tranches
had been highly rated. One of them provided a return of almost 47 percent
between 2003 and early 2007, but used a great deal of leverage and some
exotic investments to achieve those returns.
The government charged that the hedge fund managers had discussed the
deteriorating condition of the two hedge funds four days before they told
investors that they were quite comfortable with the hedge fund investments.
In one e-mail, Cioffi stated that it was either a meltdown situation or was the
greatest buying opportunity ever, but that he was leaning toward the meltdown
scenario. He also asserted that the subprime market was looking “pretty damn
ugly.” In another e-mail, Tannin stated that the subprime market was “toast.”
However, the two men discussed the e-mail, brought it to the attention of a
supervisor, and concluded that Tannin was wrong. In the end, the government’s
prosecution failed, as both were acquitted of all charges by a jury in November
2009. This was a highly embarrassing setback for the government, which had
been threatening widespread prosecutions of executives managing subprime
portfolios or instruments that caused large losses to investors.
James E. Cayne, Bear Stearns’s chairman and CEO, sought to reassure
Wall Street that these problems had not damaged the viability of the firm. He
pointed out that it had $11.4 billion in cash holdings and had strong credit lines
that allowed for longer-term borrowings. Nevertheless, Bear Stearns shares hit
a twelve-month low of $106.55 in August 2007. Confidence in the firm was
further undermined after Warren Spector, head of stock and bond trading at
Bear Stearns and heir apparent to Cayne, was fired. The hedge funds that had
collapsed were under his supervision. Nonetheless, he received a $23 million
severance package.
Bear Stearns was a significant force in the mortgage markets as a trader and
underwriter of mortgages and related products. As a result, the subprime crisis
had a severe effect on its business. Losses continued to mount, resulting in a
third-quarter loss of $854 million—the first quarterly loss in the eighty-four-
year history of the firm. Bear Stearns also suffered a loss of its prime broker-
age business as a result of concerns over its stability, and it sought outside
investors to boost its capital. The firm was on the ropes, and its demise would
shake Wall Street to its core.
The Credit Crunch and Private Equity
The first cracks in the private equity market began appearing in June 2007,
when Kohlberg Kravis & Roberts (KKR) encountered difficulties in raising
financing on the leveraged loan market. Many private equity deals were an-
nounced on Mondays, coining the term “Merger Monday.” On Monday, June

25, 2007, however, only seven private equity acquisitions were announced,
down from forty-three the previous week and eighty-four deals announced on
June 4. Somewhat ominously, Bank of America CEO Kenneth Lewis stated
publicly that his bank was turning down private equity deals that it might have
previously financed. Those words presaged one of the worst credit crunches
ever experienced in the United States.
The last major credit crunch occurred between 1989 and 1992. Especially
hard-hit during that crunch was commercial real estate lending, a problem
that spread to business loans. The credit crunch that began in mid-2007 hit the
private equity firms first but soon spread to medium-size business loans and
even small businesses. The growing crisis in the real estate market in 2007
caused the banks to tighten credit requirements and cut back on credit, creating
a credit crunch for private equity and other businesses.
The private equity buyout binge peaked in July 2007 as the credit crunch
tightened. Leveraged loans to private equity groups were an early victim of
that credit crunch. Banks that were willing to underwrite syndicated loans for
billions of dollars shut down much of that lending because of concerns that
losses could spread throughout the credit markets. Private equity deals virtually
stopped in August 2007 as the credit crunch further tightened.
Thomson Learning was sold to Apax Partners and the Ontario employees
pension fund for $7.75 billion, but Apax had to scale back its bond sales to
finance that acquisition, in the face of a declining appetite for such offerings
and rising interest rates. They also had to eliminate a “pay-in-kind” provision
that had been used in the KKR takeover of RJR Nabisco and which allowed
interest to be paid in cash or bonds.
Another effect of the credit crunch was to disrupt closings of acquisitions
agreed to before the credit crunch. Cerberus Capital Management walked away
from a $6.6 billion takeover of United Rentals, an equipment leasing company;
a suit against Cerberus over that failed transaction was dismissed. Cerberus
also took a pounding from large investments in Chrysler and GMAC, the auto
financing arm of General Motors. Its $7.4 billion investment in Chrysler in
2007 was worth only $1.4 billion as 2008 ended.
In another aborted deal, KKR and Goldman Sachs backed out of an agree-
ment to purchase Harman International for $8 billion because of a material
adverse change in the market that could be used to invoke a walk-away clause
in the purchase agreement: Harman’s business was deteriorating. Previously
walking away from a deal was practically unheard of on Wall Street, but the
credit crunch had changed the rules. The breakup fee for the transaction was
$225 million plus expenses, a total of $400 million.
Thomas H. Lee Partners and Bain Capital withdrew from an agreed $19
billion purchase of Clear Channel Communications. A consortium of six banks,
including Citigroup, Deutsche Bank, and Wachovia, reneged on their deal to
provide nearly $20 billion in financing to those two private equity firms. A
misdirected e-mail disclosed that the banks formulated a plan to evade their

commitment as the credit crunch worsened. The banks confronted the pros-
pect of immediately losing $2.65 billion, the amount that such debt was being
discounted for in the markets. Agreement was reached in May 2008 allowing
the buyout to be completed in July.
Two equity investment funds managed by Thomas H. Lee Partners suffered
losses of about 40 percent during the first eleven months of 2008. The firm,
founded in 1974, became famous after it purchased the Snapple juice company
for $135 million in 1992 and sold it two years later to Quaker Oats for $1.7
billion. In another deal, in which Thomas H. Lee Partners partnered with Bain
Capital, the information systems of TRW were purchased for $1.01 billion in
1997 and sold a few weeks later for $1.7 billion. Those salad days were gone.
Thomas H. Lee Partners’ $500 million investment in Refco, a large commod-
ity brokerage firm, suffered a major hit when Refco went bankrupt shortly
after it made its initial public offering (IPO) in 2005. Refco failed after it was
discovered that the company had been concealing massive losses on its books.
Thomas H. Lee left his namesake firm in 2006 and started another equity group
called Lee Equity Partners. He planned to take one of his hedge funds public
in 2006 but dropped the idea as the market became unsettled.
Other private equity firms withdrew from agreed acquisitions in 2007. One
such pullout required the payment of breakup fees in the case of the SLM Cor-
poration totaling $900 million. These breakups were due to the withdrawal of
financing commitments from banks and investment bankers, including Lehman
Brothers Holdings and JPMorgan Chase. J.C. Flowers lost $1.35 billion in a
vain effort to rescue Washington Mutual, the giant mortgage lender. Flowers
nearly sustained another large loss when it appeared that Hypo Real Estate
Holdings in Germany, in which it had invested $1.7 billion, was about to fail.
However, the German government came to the rescue and put up $68 billion
to keep the firm from failing.
Home Depot reduced the price of a supply business that it was trying to
sell to private equity investors by 18 percent from what had been agreed to
just a few months earlier. Penn National Gaming announced in July 2008 the
breakup of a proposed $6.1 billion sale of itself to two private equity firms,
Fortress Investment Group and Centerbridge Partners. Instead of a buyout, Penn
National was given a $225 million breakup fee and a $1.25 billion minority
investment. Previously, private equity had eschewed minority investments,
preferring instead leveraged buyouts (LBO) of the entire company. David
Bonderman of TPG, who had previously rejected such minority positions, was
among those who decided that it was not such a bad idea, after all.
Blackstone Group and General Electric withdrew from a previously agreed
purchase of PHH. Blackstone was unable to obtain the $1.7 billion needed
to fund the acquisition because of the ongoing credit crunch. Alliance Data
Systems sued the Blackstone Group after it pulled out of a $6.4 billion buyout
of that firm. This was the second such suit filed by Alliance. A group of banks
tried to salvage a private equity deal involving the buyout of BCE, a Canadian

telecommunications company. That acquisition had been announced in June

2007, at the very height of the private equity acquisition binge, and was ap-
proved by BCE shareholders. The $52 billion transaction would have been
the world’s largest ever LBO. The purchasers included the Ontario Teachers’
Pension Plan and affiliates, Madison Dearborn Partners, and Merrill Lynch
Global Private Equity. However, that deal fell apart because BCE auditors
could not render a solvency opinion for the business, which was required as
a condition of completion for the buyout.
The leveraged loan market was disrupted further by the inability of Deutsche
Bank and Bank of America to syndicate a $14 billion debt offering that was
needed to finance the $20 billion buyout of Harrah’s Entertainment by two
private equity groups, Apollo Management and Texas Pacific Group. Apollo
Management was also suing Huntsman Corporation in an effort to withdraw
from its precredit crunch agreement to purchase Huntsman for $6.5 billion and
to assume $4.1 billion of its debt. Apollo claimed that Huntsman’s financial
condition had deteriorated and that a merger would render both companies
insolvent. The parties finally agreed on a breakup fee of $1 billion, $675 mil-
lion of which was to be paid by Apollo, and the rest by some of the banks that
had agreed to finance the deal. Apollo was given rights that would allow it to
recover at least some of its payment.
Huntsman sued Credit Suisse Group and Deutsche Bank for their role in the
breakup, seeking $4.65 billion in damages. The case went to trial in Texas in
June 2009, but was settled by the banks before a verdict was rendered. They
agreed to pay Huntsman $632 million in damages and an additional $1.1 bil-
lion in financing. In the meantime, Apollo announced a public offering through
NYSE, but it continued to experience problems. The firm lost its entire $365
million investment in Linens ’n Things when that company went bankrupt.
Apollo’s investment in the retailer Claire’s and a large real estate brokerage
firm also suffered.
Before the subprime crisis, Apollo had averaged an annual return of 27
percent, after fees, which exceeded the 19 percent track record of Blackstone
and the 20 percent reported for KKR. Apollo was headed by Leon Black, the
son of Eli M. Black, who had committed suicide in 1975 by jumping from
the 44th floor of the Pan Am (now MetLife) building in New York because of
his anxiety over an SEC investigation into payments made by his company,
United Brands, to a foreign government official in Central America. Leon
Black got his start on Wall Street at Drexel Burnham Lambert, where he rose
to head the Mergers and Acquisitions Department. The younger Black started
Apollo in 1990, after Drexel Burnham collapsed. The investor René-Thierry
Magon de la Villehuchet had been instrumental in obtaining financing for the
start-up of Apollo while employed as a senior executive at Crédit Lyonnais;
he committed suicide in 2008 after he lost large sums for his clients at Access
International Advisors (AIA Group) in the Ponzi scheme of Bernard Madoff
(see also Chapter 5).

KKR continued its ambitious acquisition program into the fourth quarter
of 2007 despite the ongoing credit crunch. It had planned deals on its books
totaling $400 billion in September 2007. However, it had to renegotiate the
terms of bank loans for a $26 billion acquisition of First Data Corp. in the
fourth quarter as a result of the credit crunch.
Third-Quarter Problems
On July 18, 2007, a still-clueless Bernanke stated that inflation remained the
Fed’s main concern. He asserted that the jobless rate would have to rise and
excess capacity utilization would have to be reduced before concerns over
inflation could be quieted. Bernanke predicted that the U.S. economy would
expand at a moderate pace during the second half of 2007, with growth increas-
ing in 2008. In the meantime, mortgage lenders cut back their underwriting
and raised interest rates in recognition of increased risks in mortgage lending.
Mortgage foreclosures increased 58 percent in the first six months of 2007
over the same period in 2006. By July 2007, 13 percent of subprime mortgages
were in, or approaching, foreclosure. Housing inventories expanded again in
July 2007, and the problems in the subprime mortgage market were referred
to as a “crisis” in newspapers. However, Treasury Secretary Paulson stated to
the press that the situation was containable.
The stock market plunged on July 26, 2007, over concerns with increased
interest rates and lower corporate earnings. By the end of the month, the Dow
was still up 8 percent for the year, but the market showed increasing volatility.
The Dow rose to 13907.52 on July 13, 2007, but fell back a few days later after
oil prices hit $73.93 a barrel. Sales of light trucks plunged in the United States
as gas prices skyrocketed. Pushed by stock buybacks, the Dow passed 14000
on July 19, 2007, but a market sell-off occurred during the week of July 27.
Paulson sought to reassure the market on August 16, 2007, with some words
that would come back to haunt him. He blithely stated that, while the prob-
lems in the credit markets would slow growth in the United States, he did not
expect a recession. Paulson also cautioned, in another incautious statement,
that the federal government would not seek to protect borrowers or lenders
against losses. However, the seriousness of the situation had filtered into the
corridors of government. The Fed, at long last, announced concern over the
volatility in financial markets and its effects on the economy. Subsequently,
the Fed cut its interbank discount rate by twenty-five basis points on August
18, 2007, reducing that rate to 5.75 percent. However, it declined to reduce its
more widely followed, and lower, Fed funds rate, and the interbank discount
rate cut seemed to have little effect on credit markets.
Investors fled securities, pushing down Treasury security yields. On August
21, 2007, Treasury security yields had their largest drop in almost nineteen
years, suggesting a flight to quality. The Fed also found that a sharp contrac-
tion of credit extensions by banks had occurred in August 2007. In fact, the

private equity market was coming unglued as a result of the credit crunch,
which had stopped forty-six acquisitions between June 22, 2007, and August
1, 2007, that involved $60 billion in credit. Bernanke, nevertheless, opined
that, while a credit crunch and subprime problems could hurt the economy,
the Fed’s principal concern still remained inflation.
Toll Brothers announced a decline in earnings of 85 percent in the third
quarter. American Home Mortgage Investment Corporation, a large real estate
investment trust (REIT) that invested in mortgage-backed securities, stopped
operations in August and filed for bankruptcy. Impac, a residential REIT,
stopped funding Alt-A mortgages (those just above subprime) in August 2007.
Capital One shut down its Green Point mortgage operation and took an $860
million charge. Lehman Brothers closed its BNC Mortgage unit in Irvine,
California. HSBC Holdings shuttered its U.S. subprime lending operations,
though it continued other consumer finance activities in the United States
through its Household and Beneficial acquisitions, until it shut them down
entirely in 2009. Accredited Home Lenders Holdings, a San Diego–based
subprime lender, announced the closing of its subprime mortgage origination
business and layoff of much of its workforce.
The Canadian Imperial Bank of Commerce (CIBC) fired two executives
who were responsible for its nearly $10 billion in subprime loan exposure.
CIBC wrote down $2 billion to cover subprime losses from loans made in the
United States. The firm was no stranger to defaulting debtors. It had financed
some questionable Enron transactions before its collapse, and the bank paid
$2.4 billion to settle Enron shareholder class-action claims. BNP Paribas, the
giant French bank, froze the assets of three hedge funds on August 9, 2007,
because the bank could not “fairly value” their subprime-related investments.
The value of the hedge funds’ assets had been about $2.6 billion, before de-
clining about 20 percent in two weeks. A German bank, the IKB Deutsche
Industriebank, had to be bailed out by the German financial regulator and a
group of German banks because of losses from subprime investments in the
United States. The bailout totaled $4.7 billion, plus backup facilities of over
$15 billion that were put in place to keep that bank stable.
The commercial paper market was reeling, which awakened Bernanke to the
increasingly alarming indication of a serious liquidity crisis. The Fed injected
$24 billion of cash into the money markets on August 9, 2007. On August
17, the Fed issued a statement encouraging banks to access the Fed discount
window more freely. That borrowing facility was normally used only to cover
overnight or short-term cash shortfalls and not as a funding source, for which
it was now being made available. The ECB also responded to the effects of
a growing credit crunch in Europe. It injected $210 billion into its financial
markets on August 10 and 11 in order to provide liquidity.
New home construction in the United States was at its lowest level in a
decade. Existing home sales contracted by 4.3 percent in August, new home
sales fell by 8.3 percent, and housing inventories were at an eighteen-year

high. Foreclosures and delinquencies were increasing. The Senate passed a

bill to allow the Federal Housing Administration (FHA) to insure refinanced
loans for borrowers who were delinquent on payments because they could
not afford the much higher interest rates that resulted after their “teaser” rate
periods. That legislation was not signed into law until July 2008. Some mort-
gage lenders were easing payment terms for homeowners. Adjustments were
made to more than 370,000 subprime loans in the second half of 2007, but
loan adjustments became a controversial practice when they were attempted
for securitized mortgages because many investors objected to the loss they
would experience from such adjustments.
H&R Block faced large losses and had trouble selling its subprime mortgage
business at Options One. The firm took charges totaling $200 million and
laid off 620 employees. Its CEO, Mark A. Ernst, was dismissed with a $2.55
million severance package and stock options on 760,000 shares. The firm’s
CFO, William Trubeck, followed Ernst out the door with a $900,000 severance
package. Later, billionaire investor Wilbur Ross, known for his investments
in distressed companies in the steel and automotive industries, announced the
purchase of H&R Block’s mortgage servicing business for $1.1 billion. H&R
Block shareholders elected three directors to its board proposed by Richard
Breeden, the former SEC chairman and corporate monitor-turned-corporate
gadfly. Breeden opposed ongoing efforts to reduce the regulation of financial
services in the United States. He wanted more regulation, not less- or more-
coherent regulation. His reform efforts were also directed at Zales, the jewelry
chain, where his hedge fund became the largest shareholder and a member of
its board. Breeden had been given $500 million by California Public Employ-
ees Retirement System (CalPERS) to invest in a politically correct manner.
Zales was foundering after the subprime crisis struck, and Breeden was being
criticized for withholding information from the Zales board about potential
buyers. Breeden’s politically correct investment strategy was substantially
underperforming other investment funds. In the event, H&R Block’s troubles
continued. It settled a suit with the state of California for $4.85 million, in
which the firm was charged with having engaged in deceptive marketing of
“refund-anticipation loans” that were made to clients awaiting tax refunds.
H&R Block did become profitable again in 2009.
Moody’s cut ratings on 691 subprime mortgage offerings in August, placing
further pressure on the balance sheets of financial services firms. Washington
Mutual warned of increased bad loans on its books and later reported the loss
of 1,000 jobs. Citigroup investment funds sold $5.3 billion in assets in August
2007, another sign of trouble at that bank. Countrywide Financial Group pulled
down its entire $11 billion line of credit.
The SEC demanded to examine the books of Bear Stearns, Goldman Sachs,
and Merrill Lynch to determine whether they were hiding subprime losses.
The agency discovered nothing of interest even though both Merrill and Bear
Stearns later failed. Shortly after that visit, Goldman Sachs found itself facing

its first major crisis as a public company. Goldman pumped $2 billion into
its floundering $3.6 billion Global Equity Opportunities (GEO) fund, which
had lost more than 30 percent of its value during the week of August 9, 2007.
Other investors in that fund, including Hank Greenberg, the former head of
AIG, and the billionaire property magnate Eli Broad, contributed another $1
billion. The Goldman Sachs Global Alpha Fund also fell by 22.7 percent in
August, the worst-ever performance by that hedge fund. These two Goldman
Sachs funds lost a total of $4.7 billion in value.
Wheat prices soared, hitting a record $7.54 per bushel on August 7, but
the stock market was plunging. Stocks of financial service firms were under
attack from short-sellers who had been relieved of the obligation not to sell
stock except on a price increase by a change in SEC rules. As the turmoil
mounted, President Bush attempted to assuage concerns over the economy
and the market with a speech from the Rose Garden on August 31, 2007. He
proposed that the FHA aid homeowners facing foreclosure and expressed
concern over subprime mortgages with teaser rates that would reset at levels
that would create “payment shock.” Yet Paulson continued to state that the
United States should be able to avoid a recession.
The Fed suggested that the worst of the problems in the mortgage markets
was over. Bernanke sought to reassure the financial community, stating in late
August that the Fed would “act as needed” to protect credit markets. Stock mar-
kets rallied on the expectation of a rate cut. The Fed became less sanguine on the
housing market, declaring that recovery in that market was uncertain because
of tightened lending standards and higher interest rates. It also stated that the
downturn in the housing market was threatening the broader economy. In the
meantime, Moody’s downgraded another 149 subprime investment vehicles. As
September 2007 began, the Bank for International Settlements (BIS) predicted
that the mortgage market turmoil was receding and normality could be expected
to return. A sharp market sell-off followed that prediction. The ECB pumped
$104 billion into the European money market on September 12, 2007.
The Bush administration wanted Fannie Mae and Freddie Mac to be given
expanded powers in order to allow them to provide support in the ongoing
mortgage crisis. Instead of acting as rescuers, however, it appeared that these
GSEs were themselves in trouble. Freddie Mac announced a third-quarter
loss of $2 billion. Fair-value accounting took its toll at Freddie Mac, which
reported a decrease in the fair value of net assets of $8.1 billion for the third
quarter of 2007, compared with an increase of approximately $300 million for
the same period in 2006. Fannie Mae lost $1.39 billion in the third quarter. A
$2.24 billion decline in the value of derivative contracts and $1.2 billion in
credit losses contributed to that quarterly loss.
Fannie Mae also published accounting statements for the first two quarters
of the year, bringing it up to date on its financial reports. The news in those
reports was not good. It was reported that the fair value of its assets fell by
$8.7 billion in the first three quarters of 2007.

Fair-Value Accounting
A problem that was bedeviling the burgeoning subprime crisis was the concept
of fair-value accounting for financial instruments, standards for which are set
in the United States by the Financial Accounting Standards Board (FASB), a
private body.
The foundational ideas associated with fair value accounting were adopted by FASB
in Statement of Financial Accounting Standards (FAS) 115 [in 1993]. The rule di-
vided financial assets into three categories—those held “to maturity,” those held “for
trading purposes,” and those “available for sale.” Each of these categories is treated
slightly differently. Assets held to maturity are valued at amortized cost; assets held
for trading are marked to market, with unrealized gains or losses included in earnings;
and assets deemed available for sale are marked to market, with unrealized gains or
losses excluded from earnings but included in shareholders’ equity.17
That concept was further advanced with FASB’s SFAS 157, adopted in
2006, just as the subprime market peaked, and became effective for fiscal
years beginning after November 15, 2007, just as the subprime crisis was in
full bloom. SFAS 157 specified conditions on how fair value was to be de-
termined, but placed the greatest emphasis on the use of market prices. This
requirement meant that financial assets whose value was being determined
using these standards were subject to having their stated value reduced, or
“written down,” if they were negatively affected by market conditions. The
FASB also announced on September 6, 2006, that it was repealing a ban on
using the “mark-to-market” valuation method for financial instruments whose
value was not known.
Many subprime mortgage instruments were not actively traded and were
difficult to value, particularly as foreclosures mounted and mortgage-backed
securities were downgraded. Accounting firms, badly stung by the overvalu-
ations at Enron and elsewhere, were taking a hard line on marking down the
value of subprime securities. Because the valuation of these instruments was
difficult, and any overstatement could be prosecuted, this meant that those
securities had to be marked down to levels well below their actual value. The
result was to further undermine subprime securitizations, creating more un-
certainty, which resulted in more markdowns, which created more uncertainty
and so on, touching off a cascade effect that that would eventually undermine
the entire economy.
Fair-value pricing led to a downward spiral of writedowns that bore no
relation to actual value. As Peter Wallison, an American Enterprise Institute
fellow, noted in the midst of the subprime crisis:
As losses mounted in subprime mortgage portfolios in mid-2007, lenders demanded

more collateral. If the companies holding the assets did not have additional collateral
to supply, they were compelled to sell the assets. These sales depressed the market
for mortgage-backed securities (MBS) and also raised questions about the quality
of the ratings these securities had previously received. Doubts about the quality of

ratings for MBS raised questions about the quality of ratings for other asset-backed
securities (ABS). Because of the complexity of many of the instruments out in the
market, it also became difficult to determine where the real losses on MBS and ABS
actually resided. As a result, trading in MBS and ABS came virtually to a halt and
has remained at a standstill for almost a year. Meanwhile, continued withdrawal of
financing sources has compelled the holders of ABS to sell them at distressed or
liquidation prices, even though the underlying cash flows of these portfolios have
not necessarily been seriously diminished. As more and more distress or liquidation
sales occurred, asset prices declined further, and these declines created more lender
demands for additional collateral, resulting in more distress or liquidation sales and
more declines in asset values as measured on a mark-to-market basis. A downward
spiral developed and is still operating.18
The effort to ease fair-value accounting developed into trench warfare be-
tween corporate activists who wanted the requirement continued and much of
the business community, which wanted it suspended. Robert Hearst, the head
of the FASB, asserted in December 2007 that the United States was losing
credibility in the financial markets because of the subprime crisis. He lamented
the fact that it had only been five years since the Enron-era scandals had created
so much turmoil in the financial markets. Hearst’s comments seemed a bit out
of place considering that his organization’s fair-value ruling was responsible
for much of the stress in the market.
The Fed Acts on Rates
After pausing for over a year since the last time it raised rates, the Fed on
September 18, 2007, cut its Fed fund rate by a surprisingly large fifty basis
points, or double what was expected. The first Fed funds rate cut in four years,
this cut pushed rates down to 4.75 percent. One economist called it “shock
therapy,” but the reduction had little success in restoring faith in the credit
markets. Existing home sales contracted by 19 percent in September.
Losses from the subprime crisis continued to mount. The Impac Companies,
a financial services firm that specialized in nonconventional residential and
multifamily mortgage originations and warehouse lending operations, stopped
mortgage lending and suspended the distribution of dividends. Also suspend-
ing dividends was NovaStar Financial, based in Kansas City, Missouri, which
originated, invested in, and serviced subprime loans that were securitized.
NovaStar sold its mortgage-servicing business to Saxon Mortgage for $155
million, as well as its loan portfolio, stopped the origination of new loans, and
cut about 1,600 jobs.
Beazer Homes, a national home builder headquartered in Atlanta, Georgia,
which built in more than forty markets in the United States, announced that
68 percent of its homebuyers had canceled their orders in the third quarter of
2007, an increase of 36 percent over the number of cancellations in the second
quarter. The company was in default on its Senior Notes.
General Motors had a third-quarter loss of $39 billion, after having reported

a loss of $38.7 billion for 2007 in the largest annual loss ever reported by
an automobile company. That year for the first time Toyota tied with GM in
automobile sales—the first time in more than seventy-five years that GM had
not been the world’s leader in total automobile sales. American automakers
were clearly struggling and would be the subject of a government rescue as
the financial crisis worsened.
In the third quarter of 2007, JPMorgan’s earnings rose to a record $3.37
billion, about the only financial services firm reporting good results. The
halcyon days of outsize earnings from the mortgage market were finished for
the rest of the financial services industry. Freddie Mac, which handled about
20 percent of all U.S. home mortgages, experienced a third-quarter loss in
2007 of $2 billion. It faced losses of as much as $12 billion on its portfolio of
mortgages. Freddie Mac cut its dividend in half in order to shore up its capital
base. The GSE also issued $6 billion in preferred stock in November 2007 to
investors who would soon come to regret that investment choice. Fannie Mae
had a third-quarter loss of $1.39 billion. It was then holding or guarantying
$2.7 trillion in mortgages.
Washington Mutual issued a profit warning and reported a 70 percent decline
in profitability for the third quarter. At Bank of America earnings fell by 32
percent, and it cut 3,000 jobs. General Electric (GE) announced that it was
taking a $300 million to $400 million charge from mortgage-related invest-
ments and was quitting the subprime market. The firm also shut down all its
residential mortgage operations in Canada. State Street Securities was being
sued by its investors and was under investigation by various state attorneys
general in connection with mounting losses from subprime investments.
Bernanke stated on October 8, 2007, that the housing slump would continue
to be a “significant drag” on the economy through early 2008. Nevertheless,
the stock market continued to rise. The Dow Jones Industrial Average hit a
new record high on October 1, 2007, reaching 14087.55, but fell by 366 points
on October 19, 2007, as a result of weak earnings reports. The dollar was at a
record low against the euro. Oil prices surpassed $80 a barrel for the first time
in September 2007 and $90 a barrel on October 25, 2007.
The number of home sales in October 2007 was the lowest since 1999. Of-
ferings of mortgage-backed securities declined from over $38 billion in March
2007 to just over $6 billion in October of that year. Aided by lower interest
rates, November home sales rose by 0.4 percent but were still far below their
peak, and were 20 percent lower year on year. The median sales price of a
residence dropped in November 2007 to $210,200, down 3.3 percent from the
previous year. Migration to the sunbelt states of Florida, Arizona, and Nevada
slowed. Florida home sales were down 30 percent in November 2007 over the
previous year, and the median sales price fell by 10 percent.
Home prices fell by a collective 6.1 percent between October 2006 and
October 2007, as revealed in an index surveying twenty cities. Some cities
experienced even greater losses. Miami home prices fell by 12.4 percent and

Detroit by 11.2 percent. New York fared better, experiencing a loss of only 4.1
percent, while Los Angeles prices fell by 8.8 percent. Interestingly, Charlotte,
North Carolina, Seattle, Washington, and Portland, Oregon, all experienced
gains. Another, narrower index showed a collective drop of 6.7 percent in
home prices in the month of October 2007—the twenty-third month that this
index had shown a slowing or decline in residential home prices.
Despite rising signs of an impending economic crisis, some members of the
Fed were reluctant to make further rate cuts because of continuing inflation
concerns. However, Bernanke persuaded them to make a cut of twenty-five
basis points on October 31, 2007, pushing the Fed funds rate down to 4.5
percent. The Fed warned that this cut was likely its last cut because of its
continuing concern over inflation, which it then viewed as equal to the risk
of a recession stemming from the mounting housing crisis. That forecast
proved well wide of the mark, and the rate cut had little effect; the downturn
only deepened.
The Fed’s concern over inflation, though it may seem out of place in ret-
rospect, was not completely unjustified at the time. Crude oil prices were
skyrocketing, and commodity prices reached an all-time high on the Chicago
Mercantile Exchange. Soybean and corn prices attained levels not seen in
decades. A jump in wholesale producer prices in November 2007 was the
highest in thirty-four years. Diesel fuel prices set a record in November 2007
of nearly $3.50 per gallon.
The Bush administration began to stir on the housing front. In October
2007 the president announced the creation of Project Hope Now, an alliance
between the Department of Housing and Urban Development (HUD) and
mortgage lenders and loan counselors. The program was supposed to provide
voluntary assistance and counseling to homeowners having trouble paying their
mortgage. Within a few months, some 4,500 homeowners called the Hope Now
hotline every day, but complained that they received little assistance.
Subprime Problems Travel Abroad
The subprime crisis spread abroad, as exemplified in the failure of Northern

Rock, a British mortgage bank that had to be rescued by the British government
after it collapsed. The Northern Rock crisis began when it sought emergency
funding from the Bank of England in September 2007. The bank needed that
funding because it could not access the short-term money markets, which were
frozen due to the ongoing credit crunch. Northern Rock was borrowing short
term and lending long term on mortgages that it had securitized. That request
raised concern over Northern Rock’s liquidity, and those concerns turned into
a panic as depositors began a run on the bank, in the first bank run in England
in more than a hundred years. Customers withdrew $2 billion in deposits from
Northern Rock before the run was halted by the announcement, on September
14, 2007, that the Bank of England, the country’s central bank, would provide

$28 billion in funding to prevent a liquidity squeeze, a rescue arranged by

Alistair Darling, the British chancellor of the exchequer.
Northern Rock agreed to sell a portion of its mortgage portfolio to JPMor-
gan Chase, and the British government announced on January 21, 2008, that
it planned to guarantee some $58 billion in bonds to be issued by Northern
Rock. This was intended to be an alternative to nationalizing Northern Rock
and would have replaced the $28 billion lent to Northern Rock by the Bank
of England. However, the British government decided to nationalize Northern
Rock in February 2008, after efforts to keep it in the private sector failed. In
carrying out this nationalization, the British government provided $48.7 billion
in funds and guaranteed more than $50 billion of the bank’s obligations. Two
Northern Rock executives were later fined several hundred thousand dollars
and banned from holding senior posts in the banking industry.
Paul Tucker, a Bank of England official, warned in December 2007 of a
“vicious circle in which tighter liquidity conditions, lower asset values, im-
paired capital resources, reduced credit supply and slower aggregate demand
feed back on each other.”19 The British government considered increasing its
regulatory oversight of the mortgage market after the Northern Rock failure.
The European Union also examined its regulatory structure to determine
whether greater coordination was needed.
The House of Commons Treasury Committee subsequently issued a report
criticizing the Financial Services Authority (FSA), the UK’s financial regulator,
for its laxness in regulating Northern Rock. The report asserted that the FSA
had failed to allocate sufficient resources to monitor the bank, whose “busi-
ness model was so clearly an outlier.”20 The committee recommended that
the Bank of England, rather than the FSA, be designated as the lead regulator
when banks face financial difficulties. That recommendation was an apparent
effort to turn back the clock on the single-regulator concept in Britain, which
had given the Bank of England’s regulatory authority to the FSA because of
perceived inadequacies in the central bank’s regulatory abilities.
FSA regulations appeared to have other weaknesses. Some 20 percent of
merger transactions in Britain in 2007 were preceded by unusual trading activ-
ity in the stock of the companies involved, suggesting that inside information
was at play. The FSA promised more stringent regulation in the wake of the
Northern Rock crisis. Its head, Hector Sants, stated that the days of financial
services–friendly regulation in London were over and that he intended to take
strong action to ensure that the business community would be “frightened”
of the FSA.21
The problems in the United Kingdom only mounted after the Northern Rock
bank rescue. Barclays, a significant player in the questionable bank funding
given to Enron, took a $2.56 billion writedown in November 2007 as a result
of losses from its subprime activities. This led to a management shakeup at
the bank. A co-president of the bank, Grant Kvalheim, resigned, but troubles
at the bank continued. The Royal Bank of Scotland announced that it had lost

$5.8 billion in 2007 as a result of credit-related problems. The London Scottish

Bank experienced subprime losses in 2007 that impaired its capital. The bank
agreed with the FSA to shore up its capital by early 2008.
HSBC Holdings announced losses from bad debts of $7.4 billion in the first
three quarters of 2007. It sought a capital infusion from a Singapore-based
sovereign wealth fund, Temasek Holdings. In Australia, Centro Properties
defaulted on $1.1 billion in debt. Centro was a shopping mall owner that had
expanded into the United States through the acquisition of two large REITs.
It planned to refinance the short-term debt used to acquire those properties
through commercial mortgage-backed security underwriting in the United
States. However, that market was effectively shut down as a result of the
credit crunch and growing subprime crisis. Lehman Brothers was sued by an
Australian township for losses suffered from CDOs marketed by the brokerage
firm, whose value had declined by 84 percent.
Terra Securities, a Norwegian financial institution, declared bankruptcy in
November 2007 and was forced out of business by regulators as a result of
its sale of subprime instruments sold by Citigroup to eight small towns near
the Arctic Circle. Those towns experienced large losses as a result of those
investments.
The Crisis at Citigroup
Citigroup’s third-quarter earnings fell by 57 percent as a result of a $5.9 bil-

lion writedown related mostly to subprime mortgage investments. The firm
tried to allay fears in the market over its continued viability by declaring that
it had $80 billion in funding for its subprime investments. However, continu-
ing concerns over Citigroup’s exposure to subprime instruments sent its stock
plunging by 40 percent after that announcement. In fact, Citigroup faced the
very real danger of failure, a notion that had seemed inconceivable only a few
months earlier.
One of America’s premier and largest financial services firms, Citigroup
traces its origins to the City Bank of New York formed in 1812 by Revolu-
tionary War colonel Samuel Osgood. Osgood took over the New York branch
of the first Bank of the United States and reorganized it as City Bank of New
York. City Bank nearly failed in 1814 as a result of some bad loans made to
bank insiders. It also nearly failed during the Panic of 1837, but was saved
by John Jacob Astor. It exchanged its New York charter for a national one in
1865, becoming National City Bank. By 1893, it was New York’s largest bank,
with deposits of more than $100 million. National City Bank grew even more
after a merger with the Third National Bank in 1897. In 1919, National City
Bank became the first U.S. bank to reach $1 billion in assets.
National City Bank entered the securities business through the creation of
an affiliate called the National City Company, which was formed to evade a
1902 ruling of the comptroller of the currency that prohibited national banks

from engaging in investment banking activities, such as acting as an under-

writer of securities offerings. National City Bank ignored an opinion by the
U.S. solicitor general that formation of this affiliate was illegal. National City
Company became somewhat infamous for the high-pressure sales tactics and
other abuses that it employed to exploit the rising stock market in the 1920s.
Charles E. Mitchell, the head of National City Company, later became the
head of the bank. In that role, he defied the Fed’s efforts to cool the stock market
in 1929. After the market crashed that year, Congress responded to concerns
over commercial bank participation in investment banking by banning them
from such activity through the passage of the Glass-Steagall Act in 1933.
The National City Bank acquired the First National Bank of New York in
1955 and changed its name to First National City Bank of New York. The
name of the bank was shortened to First National City Bank in 1962. A one-
bank holding company, First National City Corporation was created in 1968
to become the parent of the bank in order to expand its business activities. The
name of the holding company was changed to Citicorp in 1974. Two years
later, its subsidiary, First National City Bank, was renamed Citibank.
In the 1980s Citicorp led U.S. banks in massive lending to Latin American
countries that became nonperforming. Citicorp worked its way out of the crisis
by rescheduling loans with the assistance of the Treasury Department, which
introduced a plan to securitize Latin American debt and otherwise restructure
loans. Citicorp encountered more problems in 1991 after a restructuring and
other charges resulted in an $885 million loss for the third quarter. The firm
then eliminated its quarterly dividend for the first time since 1813.
The Federal Reserve Bank of New York placed Citicorp under special
regulatory supervision in 1992 and as a part of that supervision limited its
ability to make new loans. In order to raise the capital needed to shore up
its business, Citicorp solicited an investment by Saudi prince Al-Waleed bin
Talal, who provided approximately $400 million of the $2.6 billion Citicorp
raised in 1991 and 1992. Citicorp also suffered losses from its real estate hold-
ings. It initially decided to hold nonperforming properties until the economy
recovered. However, Citicorp lost its nerve and sold some 60 percent of its
holdings in 1993 at a loss. By two years later the 40 percent that it continued
to hold had recovered their value.
Citicorp merged with Travelers Group to form Citigroup in 1998. That
megamerger conflicted with the Glass-Steagall Act, but the following year
it was repealed with passage of the Gramm-Leach-Bliley Act, retroactively
permitting the merger. As a result of that merger, Citigroup became the largest
financial services company in the world, with assets of more than $1 trillion.
Citigroup then had 200 million customer accounts in more than a hundred
countries, and it was also the world’s largest issuer of credit cards.
John Reed, chairman of Citicorp, and Sanford (Sandy) Weill, chairman
of Travelers Group, agreed to run Citigroup as co-CEOs. That friendly ar-
rangement soon turned into a battle between Weill and Reed over control of

Citigroup, a battle that Weill won. After Citigroup was caught up in the Enron
and financial analysts’ scandals, Weill began planning his retirement. The heir
apparent was Jamie Dimon, but Weill and Dimon had a falling out over the
promotion of Weill’s daughter, and Weill appointed as his successor Charles
(Chuck) O. Prince III, Weill’s long-time corporate lawyer.
Prince became CEO in 2003 and gained the additional title of chairman
when Weill retired in 2006. Two other attorneys who were appointed to be
vice chairmen of Citigroup joined Prince. The appointment of lawyers, rather
than bankers, to lead Citigroup appears to have been a reaction to the aggres-
sive attacks of Spitzer and other regulators that were causing companies to
put compliance ahead of what should have been the primary goal: building
and protecting their businesses from economic downturns. Unfortunately, the
subprime crisis demonstrated that Prince was no businessman. Indeed, his
leadership nearly cost Citigroup its franchise.
Certainly, Citigroup had not learned its lesson from the Enron debacle and
seems to have shrugged off regulatory concerns that had at one point led to
an order prohibiting the bank from expanding its business through additional
mergers. Indeed, it appeared that those restrictions were what pushed Citigroup
to expand into subprime mortgages so that it could build its business internally.
In a July 2007 interview with the Financial Times, which questioned him on
whether he had any concerns over the then-nascent credit crunch, Prince stated
that: “When the music stops, in terms of liquidity, things will get complicated.
But as long as the music is playing, you’ve got to get up and dance. We’re
still dancing.” That blasé remark came back to haunt him when Citigroup an-
nounced its third-quarter results in 2007. The firm reported a profit of $2.38
billion for that quarter, some 57 percent less than that for the same period of
the previous year. Those diminished earnings were caused by writedowns total-
ing about $6 billion, consisting of $1.35 billion for leveraged loan activities,
$1.56 billion for problems associated with subprime securitizations, and $2.98
billion for increased consumer credit costs. Citigroup had over $40 billion of
subprime exposure on its books.
Prince had to deal with the embarrassment of not only the size of these write
downs but also the fact that the bank’s initial announcement had understated
their amounts. The writedowns for the third quarter were later increased to a
total of $16 billion. Citigroup’s former chairman, John Reed, publicly rejoiced
over Citigroup’s woes. He even called the merger with Travelers a mistake,
even though he had approved it. Weill responded that the merger had been a
success, but that management after he left had been “very poor.” However,
Weill himself had put in place that management, led by Prince.
In the event, Prince lost Weill’s confidence after he fumbled the announce-
ment of the bank’s subprime losses and was forced to resign. However, Prince
was given several perks, including a car and driver and an office, as well as
vested stock holdings of $94 million, plus $53 million that he was paid while
serving as CEO. He would also receive a pension of $1.74 million per year.

Robert Rubin, the former co-head of Goldman Sachs and former treasury
secretary, became the interim Citigroup chairman until Vikram S. Pandit, who
had not long before been appointed head of Citigroup’s institutional businesses,
was selected to replace Prince. Pandit had been a senior executive at Morgan
Stanley but was ousted in an internal struggle for control of that company
between Philip Purcell and John Mack. After Pandit left Morgan Stanley, he
formed a hedge fund called Old Lane Partners, which Citigroup acquired for
$800 million when it hired Pandit, and received $165 million as his share of
the Old Lane buyout. The other co-founder of that hedge fund, John Havens,
was hired by Pandit to become the head of Citigroup’s investment bank and
alternative investment division. This was not a great deal for Citigroup. Old
Lane Partners soon ran into difficulty and had to be closed in June 2008.
Pandit quickly removed several Citigroup executives who had worked un-
der Prince and put his own management team in place. In order to bolster the
subprime mortgage market, Citibank announced that it was seeking to form a
consortium of large banks that would create a pool of $100 billion, to be used
to support the price of mortgage securities in order to prevent them from be-
ing sold at fire-sale prices as dictated by fair-value accounting requirements.
JPMorgan Chase and Bank of America joined in this proposal, which was
dubbed the Master Liquidity Enhancement Conduit (MLEC).
The MLEC proposal received support from the Treasury Department be-
cause Secretary Paulson wanted an orderly liquidation of those securities. That
effort never got off the ground and was scrapped in December 2007 because
of a lack of interest among other banks. Instead, Citigroup and other banks
began to move distressed assets onto their balance sheets, where they could
be supported by the bank’s other assets and liquidated in an orderly fashion.
In addition to Citigroup, HSBC Holdings, Société Générale, and WestLB took
similar actions to rescue their structured investment vehicles (SIVs) from
forced fire sales of assets in an illiquid market.
Citigroup had created a massive SIV program during the heyday of the hous-
ing boom that used long-term subprime obligations to fund commercial paper
borrowings. However, the commercial paper market was frozen and would no
longer accept the credit of SIVs. This put Citigroup in a bind because it had
sold “liquidity puts” on $25 billion of its SIVs that entitled their investors to
sell the notes back to Citigroup at par value.
The largest of the Citigroup SIVs were based in the Cayman Islands and in-
cluded Centauri, with $20 billion in assets, Beta Finance, Dorada, Five Finance,
Sedna Finance, Vetra Finance, and Zela Finance. Citigroup initially provided
$7.6 billion in funding to these SIVs through commercial paper purchases. It
later moved some $50 billion in SIVs onto its balance sheet, but that action
only created more unneeded pressure on Citigroup’s capital.
Citigroup turned for help from a sovereign wealth fund, the Abu Dhabi
Investment Authority, which invested $7.5 billion, giving it a 4.5 percent
ownership of Citigroup and entitling it to an annual payment of 11 percent.

The firm already had another large Middle Eastern investor, Prince Al-Waleed
bin Talal, who held a stake of similar size, which gave him great influence at
Citibank. The prince was the nephew of the Saudi king Abdullah and had a
net worth estimated at more than $20 billion. Citigroup also considered sell-
ing assets, but Weill urged Pandit not to break up the combination of financial
services that he had put together as Citigroup.
Citigroup reported a fourth-quarter 2007 loss of $9.83 billion—the largest
quarterly loss in the bank’s 196-year history—having written down its assets
by an additional $18.1 billion. Even after that writedown, Citigroup still had
$37.3 billion in CDOs on its books. For the year, Citigroup’s net income was
$3.62 billion.
UBS
UBS, a venerable Swiss financial institution that traced its origins back to
1854, was a leading global wealth manager, investment banking and secu-
rities firm, and one of the world’s largest asset managers. Its merger with
Swiss Bancorp in 1997 created what was then the second-largest bank in
the world. In addition to operating in more than fifty countries and employ-
ing more than 75,000 people around the world, UBS also had large opera-
tions in the United States, having acquired Paine Webber, one of America’s
larger broker-dealers, in 2000. The bank became heavily involved in the
U.S. subprime mortgage market through Dillon Read Capital Management
(Dillon Read), which Swiss Bancorp had acquired for $600 million before
its merger with UBS.
Clarence Dillon and William A. Read formed Dillon Read in 1922. That
investment banking firm was known for its creation of a giant investment
trust during the 1920s that suffered massive losses. However, it managed to
survive and become a leading investment bank under the guidance of Dillon’s
son, C. Douglas Dillon, who became treasury secretary in the Kennedy and
Johnson administrations. Dillon Read was used as the base for a large UBS
hedge fund, which had reported in March 2007 that it would have $50 mil-
lion in writedowns on subprime securities. That loss grew to $124 million in
May, and UBS then announced the closure of Dillon Read and takeover of its
assets. UBS’s CEO, Peter Wuffli, left the bank as a result of the Dillon Read
losses and was replaced by Marcel Rohner.
UBS issued a profit warning on August 14, 2007. By the end of September
2007, the losses from the Dillon Read positions ballooned to over $3 billion,
and UBS took a total writedown on assets of $3.42 billion and reported its first
quarterly loss in nine years. The bank also announced the elimination of 1,500
jobs. An additional $10 billion in writedowns was announced on December
10, 2007. UBS losses were associated with U.S. residential mortgages, mostly
from CDOs, and grew to $18.7 billion for all of 2007. In order to shore up
its capital, UBS sold a 12.4 percent stake in itself to Singapore Investment

orporation, a sovereign wealth fund, and an unnamed Middle Eastern inves-

C
tor for $11.3 billion.
The UBS subprime operations mimicked the “warehouse” financing opera-
tions made popular by other investment banks for securitization programs.
In a report to its shareholders, UBS described its CDO warehouse facility as
follows:
In the initial stage of a CDO securitization, the [CDO] desk would typically enter
into an agreement with a collateral manager. UBS sourced residential mortgage
backed securities (“RMBS”) and other securities on behalf of the manager. These
positions were held in a CDO Warehouse in anticipation of securitization into CDOs.
Generally, while in the Warehouse, these positions would be on UBS’s books with
exposure to market risk. Upon completion of the Warehouse, the securities were
transferred to a CDO special-purpose vehicle, and structured into tranches. The CDO
desk received structuring fees on the notional value of the deal, and focused on Mez-
zanine (“Mezz”) CDOs, which generated fees of approximately 125 to 150 bp [basis
points](compared with high-grade CDOs, which generated fees of approximately 30
to 50 bp). Key to the growth of the CDO structuring business was the development
of the credit default swap (“CDS”) on ABS [asset-backed securities] in June 2005
(when ISDA published its CDS on ABS credit definitions). This permitted simple
referencing of ABS through a CDS. Prior to this, cash ABS had to be sourced for
inclusion in the CDO Warehouse.
Under normal market conditions, there would be a rise and fall in positions held
in the CDO Warehouse line as assets were accumulated (“ramped up”) and then
sold as CDOs. There was typically a lag of between 1 and 4 months between initial
agreement with a collateral manager to buy assets, and the full ramping of a CDO
Warehouse.22
After the CDO process was completed, UBS generally sold the lower-rated,
subordinate CDO tranches to outside investors. It retained the AAA-rated
“super-senior” tranches on its own books because their triple-A rating made
them appear to be a safe investment. UBS also purchased super-seniors from
third parties. UBS’s inventory in mortgage-backed assets grew from a non-
substantial amount in February 2006 to $50 billion in September 2007.
Bank regulators in the United States had allowed reduced, favorable capital
treatment of super-seniors when carried on bank balance sheets, provided that
the super-senior had a triple-A credit rating.23 This regulatory blessing removed
any residual concerns of undue risk normally associated with subprime debt.
However, losses on the super-seniors caused about half of UBS’s total losses
in 2007. A large portion of those positions had been hedged, but only for 4
percent or less of their value, which was thought to be the maximum amount
of the value at risk. Because of market chaos, those positions were written
down in amounts far in excess of that coverage. Other super-seniors were not
hedged at all. The bank also engaged in “carry trades,” in which it was using
cheaper, short-term funding to invest in higher-yielding, long-term subprime
mortgages. UBS chairman Marcel Ospel publicly admitted that the bank had
not understood the risks posed by its subprime exposures.
UBS also had other problems. Michael Guttenberg, an executive direc-

tor at UBS Securities, pleaded guilty to securities fraud and other charges
in connection with an insider-trading scheme. Guttenberg sold information
about planned changes in analyst recommendations at UBS to David Tavdy, a
trader who then used the information to make trades that generated some $25
million in profit. Tavdy was sentenced to five years in prison. Paul Risoli, a
trader at Bank of America, who was a part of this large insider-trading ring,
also pleaded guilty and was sentenced to seven months in jail. In total, thirteen
individuals, including employees from Bear Stearns, Morgan Stanley, and
Bank of America, pleaded guilty to charges stemming from that trading. Even
more seriously, as discussed in a prior volume, UBS became embroiled in a
messy dispute with the Justice Department in 2008 over the bank’s offshore
tax shelter programs for Americans.
Money Market Fund Problems
State officials froze the Florida Local Government Investment Pool (LGIP) at
the end of November 2007, after a run on its assets was touched off by concerns
over subprime-related investments. The pool was a state-sponsored entity that
invested the funds of 1,000 municipal government units in Florida, including
school boards, that had come from bond sales, tax revenue and fees, and held
in the pool until needed by the municipalities for their operations. LGIP was
the largest of the pools of this type, which are common across the country.
It had been previously embarrassed by a $280 million loss on Enron stock
purchased while Enron was in the midst of its death throes. A prior invest-
ment disaster had occurred in another municipal investment fund in Orange
County, California, which had invested heavily in collateralized mortgage
obligations. That fund lost $1.5 billion, bankrupting Orange County, and the
Orange County treasurer, Robert Citron, was sent to jail.
LGIP promised municipalities a higher rate of return than was available
from short-term U.S. government securities. However, in order to generate
that higher return, LGIP had to invest in securities with higher risk profiles,
including subprime mortgage obligations. LGIP held some $2 billion in
subprime-related securities that were under stress, some of which had been
purchased after the problems in the subprime market had already surfaced. As
the subprime crisis started to blossom, some municipalities began a wholesale
withdrawal of their funds from LGIP. Before the run began, LGIP held $32
billion in funds, but this sum had shrunk to $14 billion before the Florida
governor froze the fund.
Florida hired BlackRock as interim manager of LGIP. Withdrawals were
then allowed from the pool but only up to an amount equal to 15 percent of
a municipality’s investment. Any additional withdrawals were subject to a 2
percent penalty. After the pool was reopened, another $1.8 billion was with-
drawn, but then the situation stabilized. BlackRock had troubles of its own,
even while seeking to rescue the Florida state fund. Moody’s downgraded a

BlackRock fund for institutional cash strategies to junk bond status at year-
end 2007. However, BlackRock announced that its fourth-quarter earnings in
2007 were up by 40 percent.
Other money market funds were suffering. US Bancorp announced in De-
cember 2007 that it was writing down $110 million in securities that it had
purchased from its own money market funds at face value in order to avoid
any losses to customers. SunTrust injected $1.4 billion into its money market
funds that had suffered losses from SIVs. Legg Mason injected $1.1 billion
into two of its money market funds as a result of losses from ABCP. That
action was taken in order to avoid any loss of customer confidence. Among
those rescuing their money market funds was Janus, which put $109 million
into its funds.
By year-end 2007, twenty financial institutions managing money market
funds had injected some $12 billion into those funds in order to cover losses
from subprime-related investments. This was designed to prevent those money
markets funds from “breaking the buck,” that is, returning less than $1 for each
$1 invested, an event that had occurred only once before, in 1994. Despite
those problems, the sums held in money market funds increased by 30 percent
as customers sought liquidity.
Asset-Backed Commercial Paper (ABCP) Problems
The subprime crisis accelerated with refunding failures of ABCP. In November

2007, ABCPs in the United States paid 4.75 percent on commercial paper, but
those rates rose to 6.16 percent in December, thereby reducing their spread. The
ABCPs were a $1.2 trillion market by August 2007, but by December of that
year they had declined by a third. At the same time, the value of non-ABCP
financial commercial paper outstanding rose to $863 billion, increasing by $9
billion in just one week in December 2007, as commercial borrowers increased
the issuance of their own paper directly rather than through an ABCP.
An ABCP crisis broke out in Canada. Canada’s fifth-largest bank, CIBC,
wrote down $3 billion from subprime losses. Twenty-one Canadian nonbank
trusts, including Coventree, were frozen in August 2007 after they were unable
to roll over the commercial paper issued by ABCPs that they sponsored. They
had more than $30 billion in ABCPs outstanding. Resurrecting J.P. Morgan’s
rescue of the New York trusts after the Panic of 1907, Purdy Crawford, a
prominent corporate director in Canada, headed a committee of banks that
tried to restructure the ABCPs. Some investors agreed to defer their claims
pending that rescue effort. However, the trusts were later placed in bankruptcy
in order to facilitate a restructuring that required the ABCPs to be converted
from short-term to long-term funding. Small investors were bought out.
Interestingly, despite these problems, the Canadian banks had not jumped
into subprime paper to a degree comparable to their American and European
counterparts and were spared the worst of the crisis.

Fed Policy
In order to pump liquidity into an increasingly cash-starved financial system,

the Fed created a term auction facility in December 2007 that conducted
biweekly auctions of $20 billion in twenty-eight-day loans to the banks. The
banks were allowed to include residential mortgages as collateral for such
loans. The money auction conducted by the Fed in December 2007 under
this facility attracted bids from ninety-three financial institutions. Concern
had been raised that participation in this facility would be low because such
borrowing might reflect or show weakness to the market. Similar concerns had
kept banks from borrowing through the Reconstruction Finance Corporation
during the Great Depression. There was no reason to worry. The bids submit-
ted were three times the amount of funds being auctioned off by the Fed. The
Fed’s subprime crisis auction resulted in loans paying an interest rate of 4.65
percent, lower than the existing discount rate of 4.75 percent.
On December 12, 2007, after a meeting in Cape Town, South Africa, the
Fed, the ECB in the European Union, the Bank of England, the Bank of
Canada, and the Swiss National Bank announced that they would coordinate
efforts to provide their banks with liquidity. The Bank of Japan also voiced
its support for that effort.
The ECB and the Fed diverged in their approach to interest rates. The ECB
still signaled that it would not reduce interest rates further, while the Fed indi-
cated that rates would be cut significantly. On December 18, 2007, however, the
ECB announced that it would offer unlimited amounts of funds to its member
banks at bargain interest rates. It stunned the financial community by disclosing
that it had already pumped more than $500 billion into 390 eurozone private
banks, twice the amount expected. The Bank of England also conducted auc-
tions, like those of the Fed, in order to inject funds into the banks. As for the
Fed, it lent almost $5 billion a day from the Fed discount window at the end
of December 2007, in addition to the biweekly auctions.
The interbank rate charged by banks to one another was in a disconnect at
year-end 2007. The spread between that rate and the Fed funds rate widened
to over 1 percent, whereas normally it was less than twenty basis points or
0.2 percent. The money market faced concerns because of the rolling over of
some $300 billion in commercial paper. That market was contracting, shrink-
ing to $748 billion in December 2007, down from its high in August of that
year of $1.2 trillion.
The commercial bond market also suffered from the credit crunch. The prices
of several corporate bond issues fell sharply as a result of fears of subprime lend-
ing exposure. Concern welled up that $600 billion in corporate bonds that would
come due in 2008 might be difficult to refinance. The spread between the interest
rates of junk bonds and Treasury securities set a record low in the first half of
2007, but that spread more than doubled in the second half of that year.
The inflation rate in the United States reached 4.3 percent on an annualized

basis in November 2007. This placed the Fed between a rock and a hard place
in setting interest rate policy. On the one hand, the Fed had viewed its principal
role as preventing inflation, which would mandate that it increase, or at least not
decrease, interest rates. On the other hand, lower rates were needed to rescue
homeowners facing large mortgage payment increases after their loan rates
reset. Lower rates were also needed to revive the moribund real estate market,
which was threatening the viability of many financial institutions. On top of
all that were concerns that the economy was slowing. After weighing these
factors, the Fed cut interest rates again on December 12, 2007, by twenty-five
basis points—but to no apparent effect.
A debate arose over how to deal with the burgeoning credit crisis and what
could be done to reduce foreclosures. President Bush advised Wall Street on
December 20, 2007, that it should take any writedowns from mortgage losses
before the end of the year. Apparently, he proposed that they take a “big bath”
so they could put their troubles behind them in the new year. Such accounting
tactics were common when new management came into a company. The losses
could be blamed on the old management, and the new management would
essentially start with a fresh balance sheet. Such tactics had been frowned on
by the SEC for years, but the growing severity of the subprime crisis seemed
to justify a little accounting manipulation.
The Bush administration also pressured banks to freeze interest rates on a
massive amount of subprime mortgages whose interest rates would reset in
early 2008, causing many defaults by borrowers. That proposal was criticized
as rewarding bad credit judgments by those borrowers. It also removed flex-
ibility for banks to work out their own arrangements with defaulting debtors,
while keeping the rewards of higher rates from nondefaulters. After all, it was
argued, the banks had incurred the risks, and they should be the ones to decide
how to work things out, not the government.
Alan Greenspan, the former Fed chairman, was among those criticizing the
Bush proposal. He advocated direct government aid to defaulting homeown-
ers, not a big government bailout. But the plan to freeze mortgage rates on
variable rate mortgages or other mortgages with reset features ran into a large
roadblock: Bank computer systems were unable to deal with those changes,
and banks were unable to comply with accounting rule requirements for this
kind of restructuring.
Other regulatory threats loomed. The Democratic-controlled Congress was
considering more regulation of bank lending activities. The Fed also amended
its regulations for subprime mortgages, which it defined as those charging inter-
est rates of more than three percentage points over that of government securi-
ties with similar terms. The Fed tightened loan documentation requirements,
which had been essentially waived by many banks during the real estate boom.
It required taxes and insurance to be placed in escrow and banned deceptive
advertising, as well as loans described as having a fixed rate that in reality
would reset. Restrictions were also levied on mortgage broker fees.

Fourth-Quarter Results
As 2007 ended Bear Stearns announced the first quarterly loss in its eighty-
four-year history. The loss was largely attributable to a decline in the value of
the firm’s subprime mortgage portfolio. Investors worried that the problems at
Bear Stearns might be worsening. Pimco, a leading global investment manage-
ment firm, with more than $747 billion in assets under management, advised
Bear Stearns in December 2007 that it wanted to unwind several billion dollars
of trades in which Bear Stearns was a counterparty. Bear Stearns was able to
push off that request, but it caused a great deal of concern at the firm.
Lehman Brothers had reported income of $807 million in the third quarter
of 2007, a decline of 3.2 percent over the previous year due to mortgage writ-
edowns. Although it had written off $3.5 billion as a result of its mortgage
activities, the firm still exceeded analysts’ expectations, reporting $886 million
in earnings for the fourth quarter in 2007. That was a decline of 12 percent
over the previous year, but Lehman’s earnings for the year nonetheless set a
record for the firm for the fourth straight year.
JPMorgan Chase reported record profits in the third quarter of 2007, but
its fourth-quarter income was down 34 percent—the first decline in quarterly
profits since Jamie Dimon had taken the helm in 2005. Goldman Sachs had
hedged its bets in the subprime market and, as a result, had a good year in
2007. The firm had only “modest” mortgage-related losses, but offsetting
positions more than covered them. Goldman’s fourth-quarter results handily
beat analysts’ predictions.
Year-end bonuses for Goldman employees were reported to average
$360,000. The head of the firm, Lloyd Blankfein, was given a pay increase
bringing him up to $70 million per year. Gary Cohn and Jon Winkelried, co-
presidents of Goldman Sachs, were each paid $67.5 million for their work in
2007. Those outlays suggested that Goldman Sachs had escaped the worst of
the credit crisis. However, a Goldman Sachs spokesman cautioned that 2008
might be less favorable. He was right.
Capital One Financial Corporation reported that its fourth-quarter 2007
profit fell by 42 percent over the previous year because of a rise in bad debts.
General Electric (GE) was hurt by the credit crunch. Although viewed by many
as an industrial firm, GE was heavily involved in finance. Its GECapital unit
made loans to small to medium-size businesses and invested in commercial
real estate. GE issued a profit warning in December 2007 and announced plans
to sell at least a portion of its once highly profitable credit card unit, which
was hit by the liquidity squeeze.
Merrill Lynch reported that it had $15 billion in subprime exposure in the
third quarter, but increased that number at year-end to $46 billion as the re-
sult of off-balance-sheet exposures from subprime CDOs called such things
as Pyxis. State Street, the manager of $2 trillion of pension and other funds,
reserved $618 million at the end of its fourth quarter in 2007 to cover losses

from subprime investments. One of its managed funds lost 28 percent of its
value as a result of subprime investments. Sovereign Bancorp took $1.61 bil-
lion in write-offs in the fourth quarter of 2007. That bank also announced the
closure of its automobile lending operations in several states. The Bank of
New York Mellon reported that its fourth-quarter 2007 profits had fallen by
68 percent, largely due to a $118 million writedown of CDOs. The Jeffries
Group, a brokerage firm that got its start in the “third market” in off-exchange
transactions in New York Stock Exchange–listed stocks back in the 1970s,
announced a $24 million fourth-quarter loss for 2007, after experiencing large
gains in the first three quarters of that year. However, its losses owed to the
large bonuses it had paid employees.
Fannie and Freddie
Freddie Mac reported a fourth-quarter 2007 loss of $2.5 billion, a record

for that entity, but seemed unfazed by that setback. Indeed, it boasted of the
purchase of $43 billion in mortgages to help some 47,000 families avoid
foreclosure. In announcing its fourth-quarter results, Freddie Mac CEO and
chairman Richard F. Syron stated: “Today’s economy represents one of the
most severe housing downturns in American history, and our results reflect
that difficult environment as well as Freddie Mac’s steadfast commitment to
its important mission of providing liquidity, stability and affordability to the
U.S. housing finance system.”24
Fannie Mae reported a loss of $2.1 billion for 2007, which did not compare
favorably to profits of $4.1 billion in 2006. Losses in the fourth quarter of
2007 totaled $3.6 billion. Those losses were driven by fair-value writedowns
of derivatives totaling $3.2 billion in the fourth quarter and $4.1 billion for the
full year. Those writedowns were due mostly to the effects of falling yields on
interest rate swaps used as hedges. This seems curious considering that hedges
are supposed to protect asset values and thereby prevent such losses.
The FHLBs were keeping the mortgage market open by lending hundreds
of billions of dollars to holders of residential mortgages, who were allowed to
use their mortgages as collateral for those loans. That lending by the FHLBs
far exceeded the amount of funds injected into the financial system by the
Fed. The FHLB Board lending facility was needed to offset the $500 billion
decline in mortgage securitizations by SIVs and ABCPs. Those services came
at a cost. The FHLBs reported a fourth-quarter loss of $672 million. The FHA
announced a $4.6 billion loss for 2007. At the time that announcement was
made, Congress was considering a proposal to have the FHA purchase $300
billion in subprime loans.
Corporate earnings were considerably lower in the fourth quarter of 2007 as
compared to the year before. Sprint Nextel survived the telecom shakeout that
took down WorldCom and others but still struggled in 2007. It lost wireless
customers to its competitors and eliminated 4,000 jobs as 2007 ended. Top

management was replaced. Sprint announced a $30 billion loss in 2007 and
warned of more difficulties in the following months. AOL shifted its market-
ing strategy, making its Internet service free, and sought to gain revenue from
advertising, but that effort showed little sign of success. Revenue in 2007 was
33 percent lower than in 2006.
ExxonMobil had a profit of $40 billion in 2007, the largest annual profit
ever reported by a U.S. company. That profit caused much resentment because
consumers believed it had been earned by charging them exorbitant gasoline
prices. Southwest Airlines was feeling the benefits of derivatives. That air-
line had hedged its fuel oil costs, allowing it to double its profit in the fourth
quarter of 2007. In contrast, Delta Air Lines suffered a large loss because of
increased fuel costs.
Berkshire Hathaway had a very good year in 2007. In December it bought 60
percent of Marmon Holdings from the Pritzker family in Chicago for $4.5 bil-
lion. Marmon was the holding structure for the Pritzker’s industrial enterprises.
Berkshire Hathaway’s head, Warren Buffett, planned to buy the remainder of
Marmon over the next several years as the Pritzkers carried out their plan to
liquidate the family’s enterprises. Berkshire Hathaway’s stock was up almost
30 percent at year-end. That happy condition would change in 2008.
The Conference Board’s index of leading economic indicators trended
downward in the last quarter of 2007. Several economists predicted a recession.
The number of unemployed in December 2007 was more than a million higher
than it had been at the same time the year before, an increase of 30 percent.
Gold prices jumped by over 31 percent in 2007. The dollar’s exchange rate
against other currencies was sinking. Between 1999 and 2001, the euro had
lost almost 20 percent of its value against the dollar. However, the dollar then
began faltering and fell below parity with the euro in 2002. The euro gained
10.6 percent over the dollar in 2007.
The year 2007 turned out to be a hot one for IPOs in the largest such market
in seven years. Offerings were led by foreign and technology companies, but the
bulk of them took place in the first half of the year. The largest IPOs included
the Blackstone Group, MF Global, Interactive Brokers, and Och-Ziff Capital
Management. In March 2007 Goldman Sachs joined the increasingly popular
IPOs for blank check offerings, or special acquisition companies (SPACs) that
sought funds but did not disclose what the funds would be used for. Rather,
these blind pools would look for opportunities. If they made an acquisition,
they typically were given 20 percent of that company. Goldman Sachs insisted
that the sponsors take less than the usual 20 percent fees in their offerings.
The Dow Jones Industrial Average had its worst fourth quarter in twenty
years, and it had several days with triple-digit losses, including a decline of
101 points on the last day of trading in 2007. The Dow finished up 6.43 per-
cent for the year, but that gained paled beside the 2006 rise of 16.29 percent.
Still, it was better than the small loss experienced in 2005. The S&P 500 index
ended 2007 up 3.5 percent over the previous year, which was less than the

inflation rate and lower than the yield on government securities. The Harvard
endowment fund reported a gain of more than 7 percent in 2007, a remarkable
performance in light of the losses sustained in almost all financial sectors.
However, that situation would be reversed in 2008.
Bank stocks were hammered by their subprime problems. The Dow Jones
Wilshire Banks Index was down 26 percent in 2007. Wall Street firms cut
35,000 jobs during 2007. However, the investment banks did not slow their
bonus payouts simply because of losses experienced in 2007. The amount of
bonuses rose to $40 billion in 2007, up from $36 billion in 2006.
Predictions were made that the total asset write-offs by financial institu-
tions could exceed $300 billion for mortgage-backed securities. Even some
conservative banks, like Wells Fargo, were damaged by bad credit decisions. In
its case, home equity mortgage defaults and debt consolidation loans were the
cause. Wells Fargo experienced a 38 percent decline in earnings in the fourth
quarter of 2007, its smallest quarterly profit in six years. That drop was driven
by a $1.4 billion increase in loan loss reserves. Liquidity woes spread abroad.
Eurozone banks held more than $350 billion in off-balance-sheet asset-backed
structures and leveraged loans.
Nearly a million subprime loans were overdue by thirty days or more at the
end of the third quarter of 2007. Late mortgage payments hit a twenty-one-year
high at year-end. Balances on home equity lines of credit totaled $1.1 trillion as
2007 ended, and 5.7 percent of those credit lines were delinquent in repayment.
Lenders cut back on home equity loans because the rate of delinquencies had
nearly doubled in 2007. Homeowners seeking to refinance their mortgages
encountered difficulty in having the holders of their home equity lines agree to
subordinate their claims to the new first mortgage, permission that was granted
almost automatically in the past. Some homeowners were asked to reduce
their credit lines before receiving approval. The percentage of foreclosures
and loans past due reached 7.9 percent of all loans outstanding in the fourth
quarter of 2007, the highest rate since those figures began to be compiled in
1979. Some struggling homeowners refinanced their unaffordable subprime
loans with reverse mortgages. The Bush administration sought to assist them
by proposing a five-year freeze on subprime mortgage interest rates.
Housing starts increased by an average annual rate of 8.5 percent between
January 2003 and December 2005. However, housing starts fell by an annual
rate of 21.8 percent between January 2006 and December 2007. Housing prices
dropped by an annualized rate of 23 percent between November 2007 and Janu-
ary 2008. During 2007, existing home sales dropped at a rate greater than had
been seen in the prior twenty-five years. Pending housing sales fell to the lowest
level in 2007 since such statistics began to be kept. Sales of existing homes
dropped in December 2007 by 2.2 percent. The median price also declined,
falling to $217,000, in the first such decline in price since the 1930s.
The decline in real estate prices was not uniform across the country. In
California, which led the nation in subprime mortgage originations, home sale

prices fell on average by 36 percent in 2007, and Florida saw a decline of 30

percent. This was much higher than the national average of 20 percent. The
vacancy rate for homes in the United States in the fourth quarter of 2007 rose
to 2.8 percent, tying a record set earlier in the year. The National Association
of Realtors reported that its index for pending home sales was down almost
20 percent in 2007. Housing starts hit a sixteen-year low as 2007 ended. New
construction contracted by 14.2 percent in December 2007.
Merger volume slowed dramatically in the second half of 2007. The com-
mercial real estate market also suffered in 2007. Commercial lending set a
record of $515 billion that year, mostly in the first six months of the year. Very
little lending occurred in that market during the last six months of 2007. The
national vacancy rate for commercial office buildings increased in the last
quarter of 2007—the first such increase in four years.
Corporate bankruptcies jumped by 40 percent in 2007. Among others,
ResMAE Mortgage Corporation and American Home Investment Mortgage
Corporation went bankrupt as a result of the credit crunch. Levitt & Sons, a
unit of the giant Levitt housing construction company, declared bankruptcy in
November 2007. The company halted ongoing construction, including homes
on which families had made deposits and awaited construction to be completed.
KB Homes reported a $772 million loss for its fourth quarter in 2007. The
price of that company’s stock fell by 9 percent after that announcement. CIT
Group, a New York–based finance company, issued a profit warning for 2007
and boosted its loan loss reserves. The company suffered losses on its student
loan business as well as home mortgages.
Payday Lending
The House of Representatives approved legislation in November 2007 that

would have made loan packagers for securitization and other secondary-market
resales liable for predatory lending practices even if they did not originate the
loan. That bill would require the SEC and bank regulators to set due diligence
standards that would have to be met before banks could make mortgage loans.
The measure was sponsored by Representative Barney Frank (D-MA). A bill
sponsored by then–presidential candidate Senator Christopher J. Dodd (D-
CT) would have gone further and allowed class-action lawsuits for failures by
banks to exercise due diligence in assuring that loans could be repaid. Such
legislation was not passed until 2010, and it softened these requirements but
did impose some due diligence obligations.
In the meantime, subprime borrowers looked for other sources of credit.
The number of people living in the country who were “unbanked” (that is,
who did not participate in the banking system) was estimated at more than 28
million in 2008. More than 50 million American citizens had no credit score.
Payday lenders were supplanting, or replacing, commercial banks in many
poor neighborhoods and were becoming an industry unto themselves. Some

of the larger such firms were Ace Cash Express, Advance America, Check ’n
Go, and Nix, as well as numerous local operations. Their fees ranged from
about 2 to 4 percent for a two- to four-week advance. Because of such exor-
bitant charges and other abuses, Congress effectively banned payday loans
to military personnel in 2006. Some states tried to regulate fees charged by
payday lenders.25
The bankruptcy laws were amended in 2005 to make it more difficult for
individuals to avoid repaying their debts. Homeowners in foreclosure did
not find it as easy to declare bankruptcy as it had been before, but sometimes
had few other options; thus bankruptcy filings were on the increase. The Fed
announced in March 2008 that household wealth in the United States shrank
by $533 billion in the fourth quarter of 2007, in the first such decline in five
years. The number of new jobs was lower than expected for 2007. Other signs
of slowing in the economy appeared. The number of people working part-
time increased. According to one poll, consumer confidence had plunged to a
fifteen-year low by the end of the year.
Auto loans turned into another problem for financial institutions. Lending
standards had been loosened, and delinquencies increased in number on such
loans at the end of 2007. Retail sales declined in December by 0.4 percent.
This performance was the worst in six months and was especially disappoint-
ing because it came during the holiday shopping season, on which retailers are
dependent for a substantial portion of their annual sales. Despite a doubling of
expected retail sales in November, Christmas in-store shopping was lackluster.
Retail sales weakened at the end of December 2007, and several companies
issued profit warnings.
Even high-end jewelry stores experienced a downturn in Christmas sales.
Tiffany’s issued a profit warning after the holiday season ended. Sales of other
luxury goods also declined. Internet-based holiday sales increased by 19 per-
cent, but that growth rate was well below the over 25 percent growth rate in
prior years. Outstanding credit card debt totaled about $950 billion and grew
by $20 billion in the fourth quarter of 2007.
Executive Compensation
The level of executive compensation continued to be high at financial services

firms, which reported record profits before the subprime crisis hit. In fact, the
pay was so good that one enterprising company hired an attractive model to
stand in front of Goldman Sachs’ offices and hand out $1,000 discount coupons
on corporate jet leases. A shortage of $250,000 Ferraris was also reported in
the New York area. Among the winners was Charles Schwab, who took home
more than $800 million over a five-year period. Another executive receiving
generous packages was Lloyd C. Blankfein, the CEO at Goldman Sachs, with
payouts of $54 million payout in 2006 and $69 million in 2007, which set a
new record for Wall Street CEOs. Richard Fuld, CEO of Lehman Brothers

Holdings, was given a ten-year package valued at $180 million. He was paid
more than $40 million for his work in 2007. John Mack, the head of Morgan
Stanley, received $40 million in 2006, but his pay was cut to $1.5 million in
2007, after his firm suffered subprime-related losses.
James Cayne, the head of Bear Stearns, received $163 million before 2008
began. Martin J. Sullivan at AIG was paid nearly $14 million in 2007. During
the six years he served as Merrill Lynch’s CEO, E. Stanley O’Neal was paid
a total of $157.7 million. The top five executives at Merrill Lynch received
a total of $172 million in compensation for 2006. Even while these bonuses
were being paid out, those executives were in the process of exposing Merrill
Lynch to massive losses from the subprime market.

IV
The Subprime Crisis

11. The Crisis Begins
A Crumbling Landscape
The New Year
As 2008 began, some hope existed that the worst of the subprime crisis was
past, but a number of troubling signs suggested otherwise. Some 2.1 million
houses were for sale in the United States as the new year dawned, 2.6 per-
cent of all existing homes—a figure exceeding by far the peak of 1.9 percent
experienced during market downturns over the previous twenty-five years.
About 25 percent of subprime home mortgage loans were delinquent or in
default as 2007 ended, a rate that was likely to grow. Approximately 1.8 mil-
lion subprime loans were scheduled to reset during 2008 and 2009 at interest
rates well above their initial teaser rates.
By January 2008, Wall Street financial services firms had written off more
than $100 billion in assets as a result of their subprime investments. Mortgage
defaults worldwide totaled about $150 billion, but more write-offs were ex-
pected. The rating agencies had already downgraded more than 2,500 classes of
collateralized debt obligations (CDOs), and the primary and secondary markets
for such securities had collapsed. Standard & Poor’s prepared to downgrade
another $10 billion of subprime CDOs. Ultimately, rating agency downgrades
would affect $1.5 trillion in mortgage securitizations.
The category of loans above subprime, called Alt-A, were also at risk be-
cause they, too, had been issued in large numbers at teaser rates that would
reset over the next several months. Subprime and Alt-A mortgages constituted
some 40 percent of all home mortgage loans, so the risk from defaults was not
inconsiderable. Concerns also focused on mortgage defaults at all other levels
of credit classification. Because about 55 million of the 80 million homes in
the United States were mortgaged, a substantial increase in defaults could have
devastating economic effects in the United States and abroad.
President George W. Bush sought legislation to assist homeowners hav-
ing trouble with mortgage payments. The administration initially proposed
a voluntary program under which mortgage issuers would suspend resetting
473

474 The Subprime Crisis
interest rates and increasing adjustable rate mortgages. One proposal would
have allowed low-income homeowners to refinance their mortgage through
government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie
Mac, which would also be allowed to purchase larger, “jumbo” mortgages.
That program never really got off the ground.
Economists predicted that the United States would fall into a recession that
might be one of the most severe in its history. The chairman of the Federal
Reserve (the Fed), Ben Bernanke, signaled on January 10, 2007, that the Fed
recognized that the economy was declining and that another interest rate cut
might be in order. He stated that he would, in the future, more clearly express
to the market what the Fed’s views were on the economy. This approach
reflected a departure from the calculated mumbling of his predecessor, Alan
Greenspan, who turned out to be surprisingly articulate after he left office and
wrote his memoirs. Those memoirs were remarkably free of the garbled and
unintelligible “Fedspeak” used by Greenspan for years to deflect questions and
obscure answers that might roil the markets. Although Bernanke promised to
add more transparency to the Fed’s views as a result of criticism that he was
not forthcoming and causing confusion and a loss of confidence in the market,
that promise was never fulfilled.
Losses on bank-issued credit cards mounted even for high-end consumers.
American Express reported that the rate of spending by its more than 50 million
cardholders was dropping. It had not experienced a decline in spending by its
cardholders since 2001. This was not a signal that could be ignored. About 90
percent of Americans with incomes of more than $30,000 used credit cards in
2008, and about 40 percent of all transactions were paid by credit cards, up
from 25 percent in 2000.
The retail industry was experiencing its worst sales in seventeen years
as 2008 began. At the same time, increased energy prices were a growing
concern for consumers. Crude oil prices rose by 57 percent in 2007. A single
floor trader on the New York Mercantile Exchange (NYMEX) bid the price
of a barrel of crude oil above $100 for the first time ever in January 2008.
This was a stunt, and the CFTC fined the trader’s firm, ConAgra Trade Group,
$12 million for this conduct. That price did not last the day, but the market
would soon overtake his stunt. Heating oil costs were expected to increase by
33 percent in 2008.
The Dow Jones Industrial Average was off to a rocky start. The year began
with a drop in the stock market after it was reported that the unemployment rate
had risen to 5 percent, the highest rate in over two years. The Dow experienced a
3.5 percent fall in the first three days of trading, as well as more than five declines
exceeding 200 points in the first ten trading days of the year. By January 15,
the Dow was at 12051.11, down from the high of 14164.53 reached in October
2007. Other indexes were also down. The NASDAQ fell by 3.8 percent on its
first day of trading in the new year. The Russell 2000 index of small cap stocks
was down almost 20 percent over the previous six months.

The Crisis Begins 475
The first thirteen trading days of 2008 were the worst ever for the Dow
Jones Industrial Average for that period. It fell by 507 points during the week
ending January 19, 2008. Things only got worse. Markets around the world
plunged on January 21, 2008, a day on which the markets were closed in the
United States because of the Martin Luther King holiday. Stock markets in
Germany, India, and the UK were especially hard hit, falling from 5.5 percent
to 7.4 percent. This sell-off was spurred by events at the French bank Société
Générale.
Société Générale
Société Générale (SocGen), which had been selected as Risk Magazine’s “eq-
uity derivatives house of the year,” announced a write-off of nearly $3 billion in
the fourth quarter of 2007. That write-off was needed to cover exposures from
the U.S. housing market and from monoline bond insurers in the United States
that were unable to fulfill their obligations to cover credit losses experienced by
the bank. That problem was more than matched in January 2008, when Jérôme
Kerviel, a midlevel employee at SocGen, set a new rogue trader record.
Kerviel racked up $7.2 billion in trading losses on futures contracts that
had a notional value of more than $75 billion. That loss far exceeded the $1.3
billion lost by the former king of rogue traders, Nick Leeson, who brought
down the venerable Barings Bank in 1995. Kerviel had taken this huge posi-
tion in the Dow Jones Euro Stoxx 50 Index and the German DAX Index. He
had been bullish on the market. After the bank dumped his positions, a market
panic broke out that only worsened the losses at SocGen and destabilized
markets around the world.
It was unclear what Kerviel’s motivations were because he was an employee,
with a salary of about $150,000. He had been able to hack into the bank’s com-
puters and cover up his trading losses for several months. Kerviel was given
a rather mild sentence of three years in prison and a ridiculous fine of $6.7
billion. SocGen announced that Daniel Bouton was being replaced as CEO as
a result of his failure to protect the firm from Kerviel. The plot thickened in
August 2009, when French authorities charged Jean-Pierre Mustier, the head
of the department at the bank where Kerviel worked, with insider trading. Re-
markably, another French bank, Caisse d’Epargne, announced an unauthorized
derivatives trading loss of over $800 million on October 17, 2008.
Although U.S. markets were closed on January 19, the worldwide stock
market sell-off resulting from Kerviel’s trading unsettled the Fed. In response,
it announced a 75–basis-point reduction in interest rates on January 22, 2008,
bringing short-term interest rates down to 3.5 percent. There seemed to be
some disagreement as to the historical significance of this rate cut. The New
York Times called it the largest rate cut ever by the Fed, while the Wall Street
Journal claimed it was only the largest cut in the previous twenty years. In
any event, the stock market initially plunged after it reopened on January 20,

and the Dow fell 464 points after its opening. However, the announcement of
the Fed’s interest-rate cut rallied the market two days later, and it closed to
within 26 points of its prior-day close.
Countrywide Financial
Countrywide Financial Corporation, based in Calabasas, California, was a

centerpiece of the subprime crisis. Founded in 1969 by Angelo Mozilo and
David S. Loeb, it grew rapidly, becoming the nation’s largest mortgage lender
in the early 1990s. Countrywide financed about 20 percent of all domestic
mortgages in 2006, most of which were originated by mortgage brokers and
sold to Countrywide. Between 1982 and 2003, Countrywide’s stock increased
in value by 23,000 percent. The American Banker called Mozilo the “Banker
of the Year” in 2004 as the result of his expansion of Countrywide’s lending.
That expansion would come with a heavy price.
Mozilo led Countrywide into the subprime market, and he became the sym-
bol for all that was wrong with such lending. He sold $475 million of his own
Countrywide stock between 2001 and 2006. After Countrywide collapsed in
2008, Mozilo’s compensation came under fire. Internal notes at Countrywide
revealed that the company hired two compensation consultants to assess the
appropriateness of Mozilo’s pay; the first had stated that Mozilo’s compensa-
tion was inflated. As the firm’s losses mounted Mozilo agreed to take a 79
percent cut in pay in 2007, decreasing his salary for the year to $10.8 million;
however, his stock options netted him an additional $121.5 million.
Before the subprime crisis, Mozilo was hailed as a hero for widening access
to credit for low-income families. He also assisted the wealthy and well con-
nected by arranging loans for them on favorable terms. These loans were car-
ried out through a VIP program that was internally referred to at Countrywide
as FOA (Friends of Angelo) loans. As described in Chapter 1, the VIP loan
program had been used to make numerous loans to executives and employees
at Fannie Mae. A congressional investigation during the subprime crisis also
found that Mozillo had paved the way for loans on favorable terms to several
high-profile individuals, including players with the National Football League
and the purchaser of a home from Wayne Gretzky, the ice hockey star. Mozilo
also helped the child of a casino manager buy a home in Nevada, even though
the applicant did not qualify.
Senator Christopher Dodd (D-CT) obtained loans from Countrywide, but he
denied any special treatment. Dodd asserted that he obtained the loans through
portfolio.com, but documents revealed that Countrywide had been involved in
adjusting the loan terms. The senator saved about $75,000 in interest through
these loans.1 Dodd, the chairman of the Senate Banking Committee, was
leading the Democratic response to the subprime crisis. Another member of
Congress, Representative Edolphus Towns (D-NY), had blocked Republican
efforts to subpoena Countrywide records on the VIP loan program. However,

it was revealed that Towns himself had received two loans from Countrywide,
and they were apparently made through its VIP program. FOA loans also found
their way into the 2008 presidential campaign. Senator Barack Obama’s choice
of Washington insider James Johnson, the former head of Fannie Mae, as one
of his vetters for vice-presidential candidates caused much criticism after it
was discovered that he had obtained loans on favorable terms from Mozilo.
Johnson was forced to resign from the Obama campaign.
Johnson also referred Senator Kent Conrad (D-ND) to Mozilo. Conrad
denied receiving any special treatment. However, an internal e-mail showed
that Mozilo had asked for a discount on a loan for Conrad’s beach house. In
addition, an exception was made for Conrad on a loan for a multiunit apart-
ment building that had more units than Countrywide would normally finance.
As penance, Conrad agreed to donate $10,500 to Habitat for Humanity. The
Senate Ethics Committee later cleared both Dodd and Conrad of wrongdoing,
but stated that they had used bad judgment.
Actually, it was a common practice for mortgage lenders to grant favorable
terms to individuals with personal or business ties to executives of the lender.
The populist presidential campaign of Senator Barack Obama was hit by
charges that he had received a healthy $1.32 million mortgage from Northern
Trust in Chicago on his $1.65 million home at an interest rate that was below
market. That miniscandal grew a bit after it was discovered that the wife of
one of Obama’s principal supporters, Antoin Rezko, bought the lot next door
and sold Obama a portion of that lot. Rezko was subsequently convicted on
sixteen counts of corruption.
Countrywide went on a lending spree between 2003 and 2006. Its loan
portfolio grew from $62 billion to $463 billion. Much of that growth was in
the form of subprime loans issued at initially low teaser rates. Trouble bubbled
up at Countrywide in the fourth quarter of 2006, when its earnings began to
decline as interest rates increased. Countrywide also experienced a sharp in-
crease in delinquent mortgage payments. Overall, payments were late on 19
percent of subprime loans, up from 15.2 percent before the crisis.
On July 24, 2007, Mozilo shocked financial analysts when he said: “We are
experiencing a huge price depression, one we have not seen before—not since
the Great Depression.”2 He also stated that he did not foresee a recovery until
2009, then two years away, a forecast that proved to be remarkably prescient.
However, those remarks caused a precipitous drop in Countrywide’s stock,
and the Dow Jones Industrial Average dropped by 226 points.
As concerns over the subprime market grew, Countrywide became a leading
target of critics of lending practices in that market. The company was accused
of ignoring inflated income figures in loan applications and allowing no-doc
loans through its “Fast and Easy” loan program for subprime borrowers. A fed-
eral judge authorized an inquiry into Countrywide’s loan-processing practices
after a number of problems arose with its loan documentation for foreclosures.
Among other things, Countrywide had credited payments made by a debtor to

prebankruptcy debt, which was not permitted. Countrywide agreed to settle

claims involving its documentation, a complaint that was made in a bankruptcy
proceeding in Pittsburgh. The firm had been accused of misconduct by the
bankruptcy trustee in that case for losing more than $5,000 in checks paid by
homeowners while in foreclosure proceedings.
Mozilo suffered another embarrassment when he inadvertently sent his
criticism of a homeowner’s plea for readjustment of mortgage terms to that
homeowner. Mozilo’s e-mail stated: “This is unbelievable. Most of these let-
ters now have the same wording. Obviously they are being counseled by some
other person or by the Internet. Disgusting.” In order to quell controversy,
Countrywide announced the adjustment of the terms of more than 81,000
mortgages in order to keep them from defaulting. By this point Countrywide
serviced $1.4 trillion in loans, had 900 offices nationwide, and was the largest
servicer of mortgages in the United States.
Countrywide announced in July 2007 that its earnings were down 33 percent
and issued a profit warning for the rest of the year from expected losses from
subprime mortgages. Bank of America sought to rescue Countrywide with a
$2 billion investment on August 23, 2007. Later, Bank of America purchased
$26 billion in Countrywide convertible preferred stock in order to provide it
with capital needed for its survival. Countrywide announced that it was cut-
ting its workforce by 20 percent, which meant a loss of 12,000 jobs. It also
was able to obtain $12 billion in additional financing, but the meltdown at
that company continued.
In 2007 Countrywide had its first quarterly loss in twenty-five years,
presaging the coming crisis. It took a $2.7 billion write-off on its mortgages
at the end of the third quarter in 2007, resulting in a loss of $1.2 billion for
the quarter. The situation only worsened. Countrywide Financial Group had
been valued at $24 billion in mid-2007, but faced bankruptcy as 2008 began.
In January 2008 Countrywide reported that its overdue payments from bor-
rowers had risen to 7 percent, up from 5 percent the previous year. Bank of
America then mounted another rescue effort, announcing on January 11, 2008,
that it would purchase Countrywide in its entirety for $4 billion. However,
when the Countrywide deal closed in July 2008 it was valued at only $2.5
billion, and the acquisition crippled Bank of America, at least for a time. The
once widely admired Countrywide name was changed by Bank of America
in February 2009.
The Securities and Exchange Commission (SEC) later sued Mozilo, claim-
ing that he had privately warned of the dangers of the subprime mortgages
on Countrywide’s books while publicly stating that Countrywide was under-
writing low-risk mortgages. This was a replay of the charges against Ken Lay
and Jeffrey Skilling at Enron. In internal e-mails, Mozilo stated that subprime
mortgages were “poison” and were “the most dangerous product in existence
and there can be nothing more toxic.”3
Mozilo asserted that the sales were made pursuant to a prior written plan as

permitted by SEC rules, but the SEC noted he had changed the plan on more
than one occasion to vastly increase his sales. Charges were also brought against
Countrywide’s chief operating officer (CEO), David Sambol, and its chief
financial officer (CFO), Eric Sieracki. Sambol’s lawyer charged that the SEC
was grandstanding. Mozilo settled the SEC’s claims for $67.5 million but Bank
of America agreed to pay $45 million of that amount, as well as Mozilo’s legal
expenses, leaving a mere wrist slap for Mozilo. Sambol settled for $5 million
but Bank of America picked up that entire tab. Sieracki contended that he had
did nothing wrong and paid only $130,000 to rid himself of the matter.
The Countrywide acquisition made Bank of America the country’s largest
mortgage lender, involving that bank in about 25 percent of all private sector
mortgage loans. It also brought a host of problems. The bank later agreed to
settle a class-action suit for $600 million, which charged that Countrywide had
not disclosed the risks of its lending practices. Countrywide’s auditor agreed
to pay an additional $24 million to settle claims over shortcomings in its audit
work for Countrywide. In another case, Bank of America agreed to pay the
Federal Trade Commission $108 million to settle charges that Countrywide
inflated fees associated with mortgage defaults. Bank of America agreed to
settle claims by several state attorneys general over lending practices at Coun-
trywide. More problems followed from the attorneys general of California,
Connecticut, and Florida, who demanded that Bank of America adjust the
terms of mortgages issued by Countrywide for some 400,000 homeowners
who were in danger of default. Bank of America agreed to that demand but
then found itself in the middle of a conflict with investors in mortgages that
had been securitized. Greenwich Financial Services Distressed Mortgage Fund
3 brought a class-action lawsuit, charging that this agreement with the states
was unlawful and undercut the value of mortgages that were the subject of
securitizations and that Countrywide was contractually required to purchase
at par any mortgage loan that it modified.
Mortgage modifications created another problem. Many of the securitized
mortgages were registered with and recorded in the name of the Mortgage
Electronic Registration Systems (MERS), so that when the mortgage was
transferred in a securitization no local registration fees would need to be paid.
MERS was created in 1993 at the recommendation of the Mortgage Bankers
Association, Fannie Mae, and Freddie Mac as a means of saving on those
transfer fees. Owned by a group of large banks, including JPMorgan Chase
and Citigroup, MERS serviced some 3,000 firms that paid fees for that activity.
However, MERS created some confusion for homeowners facing foreclosure
during the subprime crisis because the registration of the mortgage in MERS’s
name made it hard to tell who was the actual owner of the mortgage.4
On January 22, 2008, Bank of America reported a $5.4 billion writedown
of its assets due to subprime mortgage losses. The bank still had $12 billion
in exposure from subprime loans remaining on its books, including about $8
billion in CDOs. Bank of America’s loan portfolio was further weakened by

its $21 billion purchase of LaSalle Bank in Chicago, which had a number of
troubled loans on its books.
In order to shore up its capital position, Bank of America announced on
January 23, 2008, that it would make a preferred share offering totaling $6
billion. This soon became the public offering of choice for financial services
firms to raise capital. In the case of trust preferred stock, banks could treat the
proceeds from such offerings as Tier 1 capital required for regulatory capital
requirements but also as debt for other purposes.
The Crisis Continues
JPMorgan Chase reported on January 16, 2008, that it would write down $2.3
billion in failed mortgage investments and credit card delinquencies, a rela-
tively small amount, at least compared to the sum at Citigroup. Citigroup’s
stock had reached $57 a share in December 2007, but fell below $29 as 2008
began. Citigroup’s stock lost another 14 percent in the week ending January
18, 2008.
Citigroup reorganized its mortgage business at the beginning of the new
year in an effort to better manage losses from the subprime lending that had
caused the removal of Charles Prince as Citigroup’s CEO. The firm’s sub-
prime problems appeared to be related to its ACC Capital Holdings unit, but
its troubles were by no means over. The subprime losses at Citigroup caused
pundits to question whether that conglomerate of financial services should be
broken up because the management of such a diverse set of risks appeared to
be a task beyond its management’s ability to handle.
The Dow Jones Industrial Average fell by over 300 points on January 17,
2008, after Washington Mutual, another large mortgage lender, reported a loss
of $1.87 billion in the fourth quarter of 2007. Merrill Lynch and Citigroup
announced on January 15, 2008, that they would seek a total of $21.1 billion
in new capital from foreign and domestic investors, which included sover-
eign wealth funds from South Korea, Singapore, Kuwait, and Saudi Arabia,
a Japanese bank, and the state of New Jersey Division of Investment, which
managed that state’s employee pension funds. Other investors solicited were
the Olayan Group, a private equity group in Saudi Arabia, the T. Rowe Price
Group, a mutual fund complex, and Capital Research & Management, a mutual
fund manager. Sandy Weill, who had turned Citigroup into the world’s largest
diversified financial services firm before his retirement, was also approached
for an additional investment in Citigroup.
Policy Developments
President Bush sought a cooperative effort in Congress that would provide

a stimulus to the declining economy as 2008 began. Fed chairman Bernanke
advised Congress in January 2008 that he would support tax cuts or other

stimulus to the economy. Some economists charged that Bernanke’s inter-

est rate cuts were simply a replay of what caused the problems in the first
place.
Several mayors of large cities complained at the United States Conference
of Mayors in January 2008 that the collapse of the subprime market was dev-
astating their cities because of a sharp rise in vacant homes. Perhaps more
important, their tax base was eroded by foreclosures and declining property
values. Subprime borrowers were given some tax relief by being allowed to
deduct the cost of mortgage insurance, provided that they earned less than
$109,000 annually—which, of course, limited the value of the deduction to
those with little or no tax exposure.
The crisis caused even ardent capitalists to question the role of competitive
markets. Bill Gates, of Microsoft, and once considered a ruthless capital-
ist, called for a kinder, gentler “creative capitalism” that would help less-
developed countries focus on building products and services. Gates’s remarks
were made at a World Economic Forum conference in Davos, Switzerland,
in January 2008. George Soros, the famous hedge fund manager, declared at
that conference that the subprime crisis had ended U.S. economic supremacy
and that the U.S. dollar would no longer be viewed as the reserve currency.
Soros published a book in 2008 in which he asserted that a superbubble had
developed over the past quarter century and was now bursting. He posited a
theory that he called “reflexivity,” which asserted that markets do not reflect
values but drive them. Soros later asserted that bank profits were “hidden
gifts” from the government.
Housing prices in the UK were falling. Like the United States, it faced a
“reset” crisis from loans that had been issued at teaser rates and would reset at
prohibitively higher rates. More than 4 million mortgages in England would
reset, an increase of more than 50 percent over the previous year, causing the
banks to worry about further losses. The Financial Services Authority in Lon-
don tried to bolster its image by fining the Thinc Group, a financial adviser,
$1.8 million in May 2008 for loose practices in its documentation of subprime
loans. The firm had not properly vetted borrowers to determine whether they
could repay the loans.
Inflation in the eurozone was 3.2 percent in January 2008. This was a
fourteen-year high, and the European Central Bank signaled that it would not
lower interest rates. However, European economies were slowing as 2008 be-
gan. The Hypo Real Estate Group in Germany, a commercial bank, wrote down
$580 million at the end of 2007 because of CDOs on its books. The German
bank WestLB announced on January 21, 2008, that its owners contributed $3
billion to boost its capital as a result of losses in its mortgage portfolio.
In January 2008 Warren Buffett’s Berkshire Hathaway purchased a 3 percent
stake in Swiss Reinsurance, which had taken large losses from subprime expo-
sures. Buffet contributed another $2.63 billion in January 2009. The Canadian
Imperial Bank of Commerce announced on January 14, 2008, that it would

issue $2.7 billion of its own stock at a discount in order to boost its capital.
The bank was writing down a similar amount for its subprime exposure.
The default rate on junk bonds was rising as 2008 began and was expected
to reach 5.3 percent by year-end, up from 4.7 percent in the prior year. Com-
mercial development also slowed in 2008, with construction in that sector
falling by 1.7 percent in January, the largest decrease in fourteen years. Gold
prices hit $901.60 per ounce on the Commodity Exchange (Comex) on January
14, 2008. The previous high for gold was $875 on January 1, 1980. Crude oil
prices fell to $86.99 a barrel on January 23, 2008.
Consumer spending rose only 0.1 percent in January 2008, while incomes
rose 0.5 percent. Money market fund assets rose to $2.76 trillion, as consumers
turned to cash-like investments for safety. Although the Dow Jones Industrial
Average dipped by 250 points on January 23, 2008, it rallied after a surprise
interest rate cut by the Fed rippled through the market. The Dow finished up
for the first time in five days, closing at 12270. Still the market was down from
its 2007 high. In prior stock market declines, many corporations rushed in and
purchased their own shares, causing a rally in the stock. Few such purchases
were made as the stock market fell at the end of 2007 and into 2008.
Even some large law firms were hurt by the credit crunch as their structured
finance groups were sidelined by the shutdown in the market for mortgage-
backed special-purpose entities. Cadwalader, Wickersham & Taft, a large and
old-line New York law firm, announced a layoff of thirty-five attorneys, a very
rare step for a large law firm to take. Skadden Arps, Slate, Meagher & Flom
put young attorneys on leave, at half pay, for a year.
Mortgages
Writedowns required by mark-to-market accounting resulted in $41.8 billion

in losses at Merrill Lynch, $37 billion at Citigroup, $26 billion at American
International Group (AIG), $13.5 billion at Lehman Brothers, and $12.3 bil-
lion at Wachovia. Those writedowns devastated the firms. Second mortgages
were another growing problem. Citigroup had run a “live richly” campaign
before the subprime crisis that was designed to encourage homeowners to seek
second mortgages so that they could live it up. This was lucrative business for
the banks because of higher returns on second mortgages. In 2008, however,
delinquencies on second mortgages increased at a rate about 50 percent higher
than those on first mortgages. Mortgage refinancings were up in January 2008
as lower interest rates attracted the attention of homeowners. Refinancing ap-
plications were at the highest level since March 2004.
Between July 2007 and February 2008, mortgage companies restructured
more than a million mortgages in order to ease their terms and allow the
homeowners to avoid foreclosure. About 73 percent of these adjustments in-
volved arrangements that allowed borrowers to catch up on missed payments
or to apply missed payments to the principal of their mortgage. Only about 27

percent of the adjustments involved reducing interest rates, forgiving some of

the principal, or extending the maturity date.
Nearly half the mortgages being adjusted in January 2008 were “prime”
mortgages, issued to borrowers with good credit histories. The rate of foreclo-
sures that involved prime mortgages increased by 41 percent in January 2008.
Some states sought to impose moratoriums on foreclosures to give borrowers
more time to refinance their delinquent mortgages.
At the end of January 2008, interest rates on thirty-year fixed rate mortgages
averaged around 5.48 percent. Fannie Mae, Freddie Mac, and the Federal Home
Loan Banks (FHLBs) at the time provided 90 percent of financing for new
mortgages. Fannie Mae and Freddie Mac planned to purchase or guarantee
up to 80 percent of all new home loans made in 2008, up from 55 percent the
previous year. This expansion of their role was a complete reversal from the
government’s efforts to curb those agencies’ activities after they encountered
accounting problems.
The SEC opened some thirty-six investigations related to subprime lending
losses as the crisis crested. The agency created a Subprime Working Group,
and SEC chairman Christopher Cox advised Congress that the agency was
working to create a multiprong response to the subprime crisis. Actually,
the agency did very little that had a positive effect. An example of this more
forceful approach involved Countrywide after it reported an $893 million loss
for the first quarter of 2008. Countrywide became the subject of a number of
investigations by the SEC and state attorneys general, as well as class-action
lawsuits. The SEC examined whether Countrywide had maintained sufficient
reserves in case of losses on its subprime loans.
Criminalization of the subprime crisis began in earnest in March 2007 with
an FBI investigation of Countrywide Financial for securities fraud. The FBI
was investigating whether Countrywide had properly disclosed its financial
condition to shareholders. The campaign against Countrywide Financial in-
creased with leaks to the press in March that the company’s credit files often
contained erroneous or questionable information about loan applicants. In
response to those leaks, the states of Florida, Illinois, and California sued
Countrywide in June 2008, charging that it had engaged in deceptive lending
practices when making mortgages in those states.
The federal government created a task force in January 2008 to investigate
the mortgage industry. Participants included the FBI, the criminal division
of the Internal Revenue Service (IRS), and U.S. attorneys in several cities,
including New York, Los Angeles, Philadelphia, Dallas, and Atlanta. They
investigated whether lenders had encouraged borrowers to submit inflated
income figures in order to obtain loans for which they were not qualified. At-
torney General Michael Mukasey was under fire in April 2008 for refusing to
create a more aggressive task force, like the one created to investigate Enron,
to attack subprime lenders. He calmly replied that he needed a task before
creating a task force.

Nevertheless, as the Obama administration took office, the Justice Depart-

ment announced that the president’s Corporate Fraud Task Force, which had
been created to prosecute the Enron-era scandals, was being expanded to
include six new agencies that would focus on mortgage and securitization
fraud cases. In March 2009 Democratic senators also called for the creation
of an interagency Economic Crisis Financial Crimes Task Force that would
prosecute those contributing to the subprime crisis. The U.S. Attorney’s of-
fice in Brooklyn created a task force of its own that included New York State
regulators.
The number of mortgage fraud cases increased to 1,200 in 2007, compared
with 436 cases in 2003. Prosecutors vied with one another to see who could
conduct the most prosecutions for subprime problems. The U.S. Attorney’s
office in Brooklyn appeared to exceed the Manhattan office in zeal. In the first
months of 2008, some 400 people were charged with crimes in connection
with loan schemes. “Operation Malicious Mortgage” resulted in 144 indict-
ments. The FBI claimed that losses from those crimes totaled more than $1
billion. The FBI also announced in May 2008 that it had launched thirty-four
task forces nationwide to investigate lending practices related to mortgages,
particularly subprime mortgages. One fraud scheme investigated by the FBI
involved loan brokers who required advance fees to obtain a loan but did not
extend a loan after receiving the money.
Two brokers working at Credit Suisse Securities were indicted for mislead-
ing customers as to the nature of their CDO investments. The defendants told
investors that they were investing in safe student loans backed by the federal
government. In fact, the investments involved risky mobile-home mortgages
and other subprime mortgages. Federal prosecutors indicted nineteen people
in California in March 2008 for mortgage fraud in a case in which investors
purported to extend loans to homeowners having difficulty meeting their
mortgage payments. The “investors” then refinanced the loan through a bank
and stole the equity that had been accumulated in the home.
New York attorney general Andrew Cuomo investigated Washington
Mutual in order to determine whether it had pressured appraisal companies
to use particular appraisers in order to assure that that the appraisal value of
homes would be high enough to allow a larger mortgage than was justified
by the real value of the property. Cuomo expanded his subprime investigation
to include Fannie Mae and Freddie Mac. This raised a jurisdictional issue
because both of those GSEs are federally chartered and regulated by federal
agencies. Nevertheless, Fannie Mae and Freddie Mac entered into a settlement
with Cuomo in which they agreed to adopt a code of good conduct and to buy
mortgages only from lenders using independent appraisers. Critics charged
that the code of conduct pushed by Cuomo would only increase settlement
costs for borrowers. Because Fannie Mae and Freddie Mac controlled much
of the mortgage market, this code of conduct would apply nationwide and
to most mortgages.

The Crisis Continues
The Treasury Department reversed itself as the subprime crisis worsened and
sought less regulation, rather than more, of Fannie Mae and Freddie Mac.
The Fed was under attack in Congress for its failure to detect the large risk
exposures by banks from subprime mortgages. Questions were also raised as
to how the off-balance-sheet structured investment vehicles (SIVs) had been
allowed to grow and present such dangers, particularly in light of the prior
problems at Enron with off-balance-sheet structures.
The Financial Accounting Standards Board (FASB) began to re-examine
the treatment of off-balance-sheet vehicles once again in February 2008, but
heavy industry lobbying sought to keep them off the balance sheet. The FASB
issued guidance in April 2008 that allowed banks, starting in the second quarter
of 2009, relief from fair-value accounting, which had forced banks to take
massive writedowns because their mortgage holdings were priced at fire-sale
prices unrelated to their actual value. Bernanke testified before Congress that
he expected there would be some bank failures but did not expect a recession
or a return of stagflation, the latter being a growing concern as commodity
prices rose and the economy continued to slow.
At the request of Treasury Secretary Henry Paulson, several large mortgage
lenders agreed to create new programs that would allow troubled subprime
borrowers to refinance their mortgages on more affordable terms or to freeze
their floating interest rates for five years. Paulson also asked mortgage lenders
to ease loan terms for borrowers above the subprime level. He noted that fore-
closures were increasing even for prime mortgages. This was an expansion of
an earlier program in which President Bush asked that mortgage lenders freeze
rates on subprime mortgages that reset at higher levels as 2008 began.
President Bush also cautioned in January 2008 that the economy appeared
to be slowing. Congress and the White House were sharply divided, and any
agreement on boosting the economy would be difficult to reach. Treasury Sec-
retary Paulson announced the Bush administration’s opposition on February
28, 2008, to a plan circulating among Democrats in Congress that would bail
out homeowners defaulting on their mortgages. Ironically in light of subse-
quent events, he asserted that there should be no bailouts for reckless lenders
and speculators. Rather, he proposed a market-based disciplinary approach
to meet the rising problems in the mortgage markets. Presidential candidate
Senator John McCain also announced his opposition to any government bail-
out from the subprime crisis. He stated that it was not the responsibility of
the government to bail out either the big banks or small borrowers who acted
irresponsibly and blamed the crisis on “rampant speculation.”
Representative Barney Frank, Democrat from Massachusetts and chairman
of the House Financial Services Committee, embraced any and all new regula-
tion, whatever its cost-effectiveness. He was wildly in favor of government
bailouts and sought to have subprime mortgages refinanced with mortgages

guaranteed by the Federal Housing Administration (FHA). Frank wanted

Congress to appropriate $20 billion to allow the FHA to refinance mortgage-
backed SIVs. At the same time, Senator Dodd sought the same amount to
create a new “Home Ownership Preservation Corporation.” Paulson opposed
those proposals.
Under pressure to do something, the Bush administration proposed a $140
billion stimulus package. Bush and leaders in Congress agreed on a more
inflated $168 billion stimulus package on February 8, 2008, largely a tax
rebate package that would give tax credits ranging from $300 to $1,200 to
approximately 120 million families. This seemed a strange solution because
a similar rebate had been used in an effort to avoid a recession in 2001, but
was found to have little effect on the economy. The Bush administration was
criticized by conservatives for not insisting that tax cuts be made permanent
as a part of the package in order to bolster business confidence.
The stimulus package increased the limits on loans insured by the FHA to
$700,000. However, the FHA faced a deficit in 2008 for the first time in its
seventy-five-year history. The ceiling on mortgages that could be guaranteed
by Fannie Mae and Freddie Mac was also raised by the stimulus package to
$625,000, from $417,000. Fannie Mae declared that it was planning a new
program to restructure loans for homeowners whose mortgages were “under-
water,” that is, their homes were worth less than their mortgages.
The President’s Working Group on Financial Markets (PWG) proposed broad
changes in the regulation of securitized transactions and sought regulation of
the mortgage origination process. The PWG wanted more disclosures about
the risk characteristics of structured financial instruments and a distinctive
system for rating such instruments. The PWG further sought enhancement of
risk management controls and disclosure of off-balance-sheet transactions.
Auction Rate Security Market
An auction rate security (ARS) is a form of money market investment that is

essentially a long-term bond using periodic auctions to reset the interest rate
on the instrument at market rates.
In other words, ARS are long-term bonds whose interest rates are based on short-
term market interest rates. The interest rates for ARS are typically set at a dutch
auction, which are held at seven, twenty-eight, thirty-five, and forty-nine day intervals.
. . . ARS are issued as either bonds or preferred stock and are designed to serve as
money market-type instruments. Also, it is important to note that ARS have long-term
maturity or no maturity at all. They have been marketed to rich individuals (for tax
exemption purposes) and corporate treasuries (for liquid cash on corporate balance
sheets, however taxable) as an alternative to money market funds.5
Municipalities and not-for-profit institutions issued many of these auc-

tion rate securities. There was also an active auction rate market for student
loans that many individual investors used for their short-term investments.

Minimum investments were around $25,000. The principal underwriters for

ARSs were Citigroup, UBS, Morgan Stanley, and Merrill Lynch, but other
investment bankers also offered such programs. The brokerage firms were paid
for the issuance of the securities when first underwritten. They also received
an annual fee of 0.25 percent of the value of the securities being auctioned.
Additional fees could be earned through interest rate swaps used in conjunc-
tion with the notes.
The auction rate market had about $330 billion in outstanding obligations
in February 2008. More than 400 companies, including Google, Bed Bath
and Beyond, and Starbucks, had large exposures from such investments in
the first quarter of 2008. Auction rate securities typically paid one percentage
point more than money market funds, which made them attractive to large
investors seeking a place to invest funds for a short term with the assurance
of liquidity. Liquidity, however, depended upon the success of the auctions,
which allowed investors to sell out their positions and reset interest rates for
new participants.
Problems had previously arisen in the auction rate market. An auction in-
volving MBank failed in 1989, resulting in a default. The SEC in 2006 charged
several investment bankers, including Bear Stearns, JPMorgan Securities,
Goldman Sachs, and Lehman Brothers, with manipulating auctions in order
to assure their success and favoring some customers over others. However,
those problems proved to be minor, at least in the context of the freezing of
this market during the subprime crisis.
Auctions for about $80 billion of these securities failed in the second week
of February 2008 when buyers declined to participate in sufficient numbers
to provide liquidity. In April, more than 500 auctions were scheduled during
a single day for $27 billion in ARSs, but they, too, failed. Under the terms
of many ARSs, if an auction failed, the holder would receive an interest rate
below LIBOR until new buyers entered the market, allowing the auctions to
be resumed. This meant that the holder would have to either sell at a large
discount or accept a very low interest rate. As a result of the auction failures,
ARSs posed an unexpected liquidity problem for the holder. However, it
was a liquidity issue, not a default on payments, over how low the interest
payments might be after an auction freeze. The liquidity problem could be
solved in part by using the ARSs as collateral for a margin loan until they
were refinanced.
The auction rate market slowly thawed out in May 2008. By then, about
25 percent of the market had been refinanced. Much of the rest of the ARS
market was expected to be refinanced by the end of 2008, allowing investors
to reaccess their funds. The most problematic were the student loan auction
rate notes, which reset at very low rates, even zero in some instances, when
an auction failed. As a consequence, the issuer had no incentive to refinance
those notes. Indeed, many of those issuers suffered losses in the student loan
market, and this was a way for them to ease those problems. Citigroup, Bank

of America, and UBS approached student loans authorities for a waiver of

restrictions in order to prevent auction failures, but those lenders were more
interested in a lower interest rate.
After coming under pressure from regulators and threats of investor lawsuits,
several investment banking firms agreed to buy back the ARSs that they had
underwritten. Bank of America agreed to buy back $4.5 billion in ARSs from
investors in September 2008; Morgan Stanley agreed to repurchase $4.5 billion.
Nuveen Investments, a mutual fund manager, agreed to refinance $4.3 billion
in ARSs issued by its mutual funds. However, that refinancing proceeded at
a snail’s pace well into 2009. A company called SecondMarket bought those
frozen ARSs at a discount of 13 percent.
An already troubled Citigroup announced plans to buy back more than $7
billion in ARSs. Citigroup also agreed to pay a fine of $100 million to state
regulators, which included New York attorney general Andrew Cuomo and
regulators from forty-eight other states, who charged that misrepresentations
had been made in connection with the ARS auctions. UBS, another troubled
bank, initially lowered the value of ARSs, which meant a loss to the holders of
that ARS debt who had invested in the belief that their funds were completely
liquid and free of most risk. UBS clients wrote down an average 12 percent
of the value of the securities. However, after pressure from attorneys general,
led by Andrew Cuomo, and threats of class-action lawsuits, UBS announced
a repurchase of ARSs totaling $19 billion. In August 2008, UBS agreed to
buy back more than $41 billion in ARSs as a part of a settlement with various
regulators and agreed to pay a $150 million fine.
UBS further agreed to pay $35 million to municipalities in Massachusetts
that had bought ARSs after they were told they were completely liquid, but
those investments were frozen when the auctions broke down. The bank paid
an additional $4.4 million to settle claims by the State of Massachusetts that it
had misled investors into investing in ARSs. Somewhat bizarrely, $1 million
of that amount was to be used to educate government officials about investing
in government funds.
UBS general counsel David Aufhauser, a former official in the Treasury
Department, was charged with misconduct involving his personal sales of
ARSs after he realized that the market was coming apart but before any dis-
closure to investors. He resigned from the bank, agreeing to forgo $6 million
in compensation and to pay a $500,000 fine. In addition, he was barred from
the securities business and from practicing law for two years. Another UBS
executive, David Shulman, agreed to pay a fine of $2.75 million to New York
attorney general Andrew Cuomo to settle charges that he sold his personal
ARSs on inside information that the ARS market was becoming illiquid. UBS
was also hit with an $81 million arbitration award in 2010 in favor of Kajeet
Inc. as the result of the freezing of its ARS account. This was ten times the
amount of Kajeet’s investment in the account.
Wachovia Securities was the target of ten state securities regulators inves-

tigating its role in the ARS market. It agreed to repay investors more than
$8.5 billion in a settlement with state regulators concerning its ARS sales. A
similar agreement was reached with the SEC in 2009, and Wachovia agreed
to pay a fine of $50 million. In March 2009, Wachovia and Citigroup were
forced to pay California investors $4.7 billion over auction rate claims, plus
more than $12 million to regulators. Bank of America reached a settlement
with the state of California to repurchase $3 billion of ARSs sold in that state.
In another settlement, Wachovia and Citigroup agreed to pay $880 million
to settle a case brought by the state of Michigan over auction rate securities.
Morgan Stanley repaid its ARSs investors $4.5 billion plus penalties of $35
million. JPMorgan agreed to return $3 billion to ARS investors and pay penal-
ties of $25 million.
Merrill Lynch, already staggering from subprime losses, was also under
attack for its ARS underwriting. Merrill Lynch was charged by the state of
Massachusetts with engaging in fraud by co-opting firm’s independent financial
analysts in their assessments of ARSs. The state charged that a Merrill Lynch
executive, Francis Constable, had pressured the Merrill research department
to retract a report by Martin Mauro that criticized the ARS market and thus
could undermine it. The state further charged that, in other sales presentations,
Merrill Lynch made positive statements about the ARS market even while
Merrill executives knew it was having difficulties. Apparently, the massive
financial analysts’ settlement by Spitzer and the SEC during the Enron-era
scandals had little practical effect. In any event, in settlements with state of-
ficials and with the SEC, Merrill Lynch agreed to buy back $10 billion to $12
billion in ARSs.
Cuomo and regulators from forty-eight states in addition to New York con-
tinued their broad-ranging investigation into the ARS market. Three investment
banking firms reached global settlements with those regulators in August 2008.
Goldman Sachs agreed to buy back $1.5 billion of ARSs from retail investors
and pay a $22.5 million penalty. Deutsche Bank agreed to buy back $1 billion
of those securities and pay a $15 million fine. In all, Cuomo and other regu-
lators forced brokerage firms to repurchase $60 billion in ARSs. Still, some
400 businesses holding over $20 billion in ARSs remained locked into those
investments because they were not protected by these settlements.
The firm of Charles Schwab refused to settle and was sued by Cuomo in
August 2009. Schwab blamed the problems on the underwriters of the ARSs.
Charles R. Schwab, the founder of the company and a pioneer in discount
brokerage, decided to fight back. He responded with an op-ed piece in the Wall
Street Journal that pointed out that his company did not recommend ARSs
to clients because it is a discount broker that does not provide such services.6
Traditionally, discount brokers were not held accountable for assuring that
their clients’ investments were suitable in light of their individual needs. This
is because, unlike full-service brokers, which are subject to a “suitability”
requirement, discount brokers do not make recommendations to their cus-

tomers. Schwab stated that if discount brokers become liable for their clients’
purchases, they would have to become full-service brokers and charge much
more for client transactions. In November 2008, Massachusetts regulators
charged executives at Oppenheimer with liquidating $3 million of their personal
holdings in ARS before advising their customers of problems. The Royal Bank
of Canada agreed to buy back $850 million in ARSs. TD Ameritrade agreed
in July 2009 to buy back $456 million in ARSs in a settlement with Cuomo,
the SEC, and Pennsylvania authorities. Wells Fargo agreed to return as much
as $1.4 billion in funds held by customers in ARSs.
A federal criminal investigation into the auction rate market focused on two
former Credit Suisse bankers. One of those bankers, Julian Tzolov, fled to his
a native Bulgaria a few weeks before his trial and was declared a fugitive from
justice. He was captured in Spain in July 2009 and pleaded guilty to criminal
charges that, among other things, accused him of misleading investors on the
risks of ARSs. The other Credit Suisse banker, Eric Butler, was convicted by
a jury in August 2009 of charges that he misrepresented ARS risks. Butler was
sentenced to five years in prison and fined $5 million.
The Financial Industry Regulatory Authority (FINRA) pursued cases against
City National Securities in California, BNY Mellon Capital Markets in New
York, and Harris Investor Services in Chicago over their ARS programs. Those
institutions agreed to repurchase some $60 million in ARSs and to pay a total
of over $700,000 in fines. FINRA established a special arbitration procedure
for ARS customers who claimed lost profits and lost opportunity costs due to
the freezing of their funds in these securities. The agency also ordered Credit
Suisse to pay $406 million to an institutional account because of unauthorized
investments of that customer’s funds in ARSs.
A federal district court dismissed a class-action suit under federal securi-
ties laws that had been brought against Northern Trust Securities, which had
refunded the monies of its ARS investors. The court held that the plaintiffs
could claim no damages beyond the amount of their investment.7 A class
action against Raymond James Financial for its ARS sales was also dis-
missed.
More Problems
Crude oil prices closed above $100 a barrel for the first time on February 20,
2008. The Dow Jones Industrial Average dropped to 12266.39 on February
29, 2008, and the dollar hit a record low against the euro on that date, having
dropped by 40 percent against that currency during the crisis. Manufacturing
activity in February 2008 was at a five-year low, and construction spending
was shrinking. More than 63,000 jobs were eliminated in February, a five-year
high. Automobile sales declined by 10 percent during February. Even Berkshire
Hathaway encountered choppy waters, reporting an 18 percent decrease in
profit from investments at the end of February 2008. Warren Buffett declared

in February 2008 that the U.S. economy was in recession, at least under “any
common sense definition.”
Both the New York Times and the Wall Street Journal on February 29, 2008,
reported a growing concern over homeowners who simply walked away from
their homes and mortgages as they went “underwater.” The share of equity
held by homeowners in their homes declined to 48 percent that month. New
housing construction declined, and the number of building permits approved
fell to the lowest level in sixteen years. Foreclosures in some regions outpaced
new home sales. Home prices declined by 12.7 percent in February 2008 year
on year. Personal bankruptcy filings increased by 18 percent in February over
the earlier month, with an average of almost 4,000 bankruptcy petitions filed
every day—the largest amount since Congress had made consumer bankruptcy
more difficult in 2005. Retail sales in February 2008 were better than expected
but still weak.
Debt instruments fell in price, pushing up their yields. The county govern-
ment of Birmingham, Alabama, faced bankruptcy because of collateral calls
totaling $400 million that were the result of a credit downgrade for the county.
The SEC sued Larry Langford, the mayor of Birmingham, for accepting over
$150,000 from a friend who was a member of an investment banking firm that
received fees from swap contracts and municipal bond offerings by the city.
The mayor’s friend was William Blount, chairman of Blount Parrish, who had
long been a thorn in the SEC’s side for having unsuccessfully sued to stop
implementation of a rule prohibiting “pay-to-play” practices for municipal
bond underwritings.8 These payments involved political contributions by
municipal securities underwriters to municipal officials in order to win their
underwriting business.
The SEC charged that Langford had selected Blount Parrish to participate
in every Jefferson County municipal bond offering and security-based swap
agreement transaction during 2003 and 2004, earning Blount Parrish over $6.7
million in fees. Langford and Blount concealed the payment scheme by using
a political lobbyist as a conduit. The case was the SEC’s first enforcement ac-
tion involving security-based swap agreements. Langford and Blount, as well
as Al LaPierre, a lobbyist, were also later indicted for these activities. Blount
and LaPierre pleaded guilty and testified against Langford. Their cooperation
earned them reduced sentences of four years. As usual, after Langford refused
to plead guilty, a superseding indictment was obtained that piled on more
charges. Langford was convicted by a jury and was sentenced to fifteen years
in prison. He was sixty-two years old. It was also revealed that Langford had
won over 500 gambling jackpots totaling over $1.5 million at a casino owned
by a political supporter.
Other municipal governments were facing losses from credit derivatives
they had purchased to protect themselves from interest rate increases during
the period when the Fed was driving up rates. Those contracts required large
payments from the municipal governments when interest rates were slashed

during the subprime crisis. Los Angles was paying $20 million a year on one
such contract to Bank of New York Mellon Corp. and Dexia SA. Ambac was
suing the Bay Area Toll Authority in California for an additional $52 million
from swap contracts on which the Authority had already paid $104.6 million.
Among the other state and local governments suffering losses from such
transactions were New York, New Jersey, Massachusetts, Oregon, Chicago,
Philadelphia, Denver, and Kansas City. Five Wisconsin school districts lost
$35 million in corporate CDOs and were facing losses of another $150 mil-
lion. The school districts were suing the Royal Bank of Canada and others,
claiming that that they were misled on the risks of the transaction.
Crude oil prices reached $103.95 per barrel on March 3, 2008, but when
adjusted for inflation this was lower than the $39.50 a barrel reached in April
1980 during the second oil shock. Still another record, $104.52, was reached
on March 5, 2008. President Bush accused the Organization of Petroleum
Exporting Countries (OPEC) of injuring the U.S. economy by maintaining
high prices and refusing to increase production. OPEC replied that the high
prices were due to speculators and mismanagement of the U.S. economy. More
concern was raised when the Department of Energy announced an unexpected
decrease in supplies in inventory on hand in the United States. Reacting to
that news, the price of gold closed at $986.20.
Canada cut its interest rate by half a point on March 4, 2008, while Australia
raised its rate by a quarter of a point. Meeting two days later, the European
Central Bank decided not to raise interest rates, which pushed the euro to a
new record against the dollar—$1.537. The dollar was also sliding against
the yen.
On March 4, 2008, Bernanke asked banks and mortgage companies to in-
crease their efforts to refinance loans by reducing principal in order to avoid
widespread foreclosures. He was particularly concerned over mortgages with
balances in excess of the value of the homes on which they were secured.
However, a study by the Federal Reserve Bank of Boston found that the reason
for most subprime foreclosures was the homeowners simply walked away
when housing prices fell.
The Fed continued to broaden access to its loan window. In the first two
weeks of March 2008, it made $400 billion available in lending and allowed
banks to post increasingly risky collateral to support those loans. This did not
stop the slide. The Fed responded to the market downturn by making $200
billion available for short-term lending by banks. A front-page story in the
New York Times on March 9, 2008, called the increasing refusal of commercial
banks to lend money even to creditworthy customers “irrational despondency.”9
An index used to measure premiums on default insurance for 125 companies
showed an extraordinary increase in March 2008, which indicated the growing
panic in the credit markets.
On March 1, 2008, Citigroup announced the layoff of 2,000 more employees.
Three days later the firm’s share price fell below book value. The Dow Jones

Industrial Average fell to 11893.69 on March 7, 2008, and was down by 10

percent for the year. The S&P 500 Index fell by 17 percent between October
2007 and March 2008. The Dow Jones declined by over 150 points on March
10, 2008. However, it experienced its best day in five years on March 11, 2008,
rising by over 400 points.
Crude oil prices rose to a new record on March 12, 2008, at $109.92 a
barrel. Inflation reached 4.3 percent in March 2008, but the five-year TIPS
(Treasury Inflation Protected Securities) had a negative rate of return. The
dollar hit another record low against the euro, and more economists stated
that United States was in recession. The Fed on March 11, 2008, made an
additional $200 billion in credit available to banks and allowed them to use
private mortgage-backed securities as collateral for those loans. The Fed had
previously allowed only mortgage-backed securities from GSEs, such as Fan-
nie Mae, Freddie Mac, and Ginnie Mae to be used as collateral. The Treasury
Department announced a new initiative on March 12, 2008, to revamp the
existing regulatory structure over the lending industry. Secretary Paulson also
stated that he would seek to regulate mortgage brokers. President Bush and
British prime minister Gordon Brown established a joint working group to
develop proposals for monitoring and regulating the banking systems of their
two countries. This working group was to develop proposals for responding
to the ongoing banking crisis.
Standard & Poor’s raised its estimate on March 13, 2008, as to the expected
amount of subprime-related losses. Its prediction was $285 billion, $20 billion
more than its earlier forecast. By mid-March 2008, financial institutions in the
United States, Canada, and Europe had already written off over $180 billion
in subprime securities values in their inventories. Bush faced the press on
March 14, 2008, in order to reassure the country that the economic situation
was under control. He rejected calls for protective trade barriers and asked for
his tax cuts to be made permanent in order to provide certainty to investors.
Somewhat oddly, the president also lamented the fact that many universities in
the United States were incapable of, or unwilling to, modify their curriculum
to provide new opportunities for students that would allow them to compete
in a global environment in jobs that were something more than menial.
Crude oil traded at over $110 per barrel on March 14, 2008. However,
American drivers cut their driving time by 4.3 percent during March, the first
decrease since 1979. The Fed cut interest rates again on March 16, 2008, reduc-
ing the bank discount rate by 0.25 percent, which left the discount rate at 3.25
percent. Gold reached another record of $1,001.40 the next day. Another Fed
rate cut on March 18, 2008, cut its short-term Fed funds rate to 2.25 percent
in the sixth cut to this rate in as many months. The market was hoping for
a full-percentage-point cut, but that was enough to trigger a rally. The Dow
Jones jumped by 420 points, to 12392.66, that day. The yield on short-term
U.S. Treasury securities nonetheless reached a fifty-year low two days later,
driven by investors fleeing to safety.

California issued $1.75 billion in debt in March 2008 without having cov-
erage from a bond insurer. Municipal bond rates soared. The average yield
on a high-quality thirty-year tax-free municipal bond reached 5.14 percent,
up from 4.25 percent at the beginning of January 2008. The California Public
Employees’ Retirement System (CalPERS) faced nearly $1 billion in losses on
an investment it had made in undeveloped real estate in California. CalPERS
had other large losses from its aggressive real estate investments, whose value
had lost about $6 billion by June 2008.
Toll Brothers had further problems because of joint venture partners who
pulled out of its projects in March 2008. Toll Brothers, KB Home, and Lennar
received default notices on $765 million in debt involving projects in Las
Vegas, which had been one of the fastest-growing areas in the country before
the credit crunch. Bruce Eichner, a developer, defaulted on a $760 million loan
from Deutsche Bank for a casino resort that he was building in Las Vegas.
CIT Group, a traditional lender to small and medium-size businesses, was
in trouble because of its investments in subprime mortgages and the credit
crunch that was cutting off access to credit. The company depleted its entire
$7.3 billion backup line of credit on March 21, 2008. More problems arose
after a publicly traded Carlyle hedge fund defaulted on collateral calls from its
counterparties that were issued on March 5, 2008, because of concern over its
mortgage exposure. Trading in the shares of that fund was suspended.
The Alt-A mortgage market totaled more than $500 billion in 2008. Thorn-
burg Mortgage, the second-largest independent mortgage firm, with a mort-
gage portfolio of some $25 billion, had difficulties. The company specialized
in Alt-A mortgages, which had a low default rate, reportedly 0.44 percent.
However, lenders on which Thornburg was dependant for financing were no
longer willing to accept its mortgages as security for its short-term funding in
the commercial paper market. Lenders also began making margin calls as UBS
and other financial institutions were writing down the value of even perform-
ing Alt-A mortgages. Thornburg received margin calls in the first two months
of 2008 exceeding $1.7 billion and defaulted on margin calls from lenders on
March 6, 2008, totaling over $600 million. Its stock price fell from about $30
in 2007 to $0.69 on March 10, 2008.
The viability of the firm was questioned by its auditors. Thornburg faced
another run on its stock on March 19, 2008, because creditors required it to raise
some $1 billion within a week. The price of the company’s stock fell by another
50 percent. Thornburg’s CEO, Larry Gladstone, blamed his company’s troubles
on fair-value accounting, which forced drastic writedowns on performing as-
sets that his company had no plans to sell. Thornburg resumed lending in April
2008, but was unable to revive its business and before long announced the firm’s
liquidation because it failed to reach a settlement with its creditors.
Small and medium-size home builders also faced a crisis as home sales
declined, which threatened regional and local banks that had made significant
loans to those developers during the housing boom. E*Trade Financial Cor-

poration also struggled because of mortgage-related losses, and its CEO, R.

Jarrett Lilien, resigned on March 19. In March 2008, the government predicted
that some 3.3 million homeowners would default on their mortgages over the
next twelve months.
Auto sales continued to fall in March 2008, not aided by the fact that lend-
ers were tightening credit standards for automobile loans. The three major
U.S. automakers and Toyota experienced double-digit declines in sales that
month. Ford Motor Company suffered a record $8.7 billion loss for the second
quarter of 2008. It agreed to sell its Land Rover and Jaguar units in March for
$2.3 billion, about half what it paid for those operations in 1989. Forecasts for
automobile sales for the rest of 2008 were gloomy: the expectation was for
them to be the lowest in fifteen years. Manufacturing activity in other areas
also declined.
Adding to the gloom, the trustees of the Social Security Administration
announced in March that the Social Security program would be insolvent by
2041, later reduced to 2037. Medicare was expected to be insolvent by 2019,
later increased to 2029. The Bush administration proposed that wealthier
individuals be required to pay more for their prescription drug benefits. That
proposal obviously portended the future. After they were bankrupt, these pro-
grams would become need-based welfare systems instead of savings programs,
which was how they were sold to the public.
The stock market was often touted as providing the highest rate of return
of any investment. However, between 1999 and mid-2008, the stock market’s
performance had been tepid, at best, and investors would have performed
equally well, or better, by investing in U.S. government securities. Among
the most popular securities issued by public companies were reverse con-
vertibles—$1,000 notes, usually with maturities of three months to a year,
that made coupon interest payments. At maturity, the investor recovered the
principal, unless the value of the issuer’s common stock fell below a “barrier”
level. If that happened, the investor would receive shares of company stock
(at the depreciated value) instead of the principal.
Bear Stearns Fails
Bear Stearns was still staggering from the failure of its two hedge funds in 2007.
James E. Cayne, Bear Stearns’s chairman and CEO, was under fire from the
press for taking long weekends to play golf while problems were brewing at
those hedge funds. Cayne and Warren Spector had also been absent at the height
of the crisis during the hedge funds collapse. They were both in Nashville,
competing in a ten-day bridge tournament. Cayne, a former scrap-iron sales-
man from Chicago, was a world-class bridge player and avid golfer. Because
of this criticism Cayne was pushed out as CEO in January 2008 and replaced
by Alan Schwartz, who was an investment banker with little experience in the
trading operations at the core of Bear Stearns’s business model.

Cayne remained as chairman of the firm. He and other members of the

Bear Stearns executive committee announced that they would take no an-
nual bonuses for 2007. However, Bear Stearns had lost the confidence of
Wall Street, and clients began pulling assets out of the firm and demanding
more collateral to cover trading exposures. Those requests came from hedge
funds, and many other large institutions sharply reduced their exposure to
Bear Stearns, including Goldman Sachs, Citadel Investment, and Paulson &
Co. Schwarz claimed that short-sellers had fueled the run on its liquidity to
enhance their own profits.
The liquidity crisis at Bear Stearns in March 2008 was heightened by its
reliance on short-term borrowing in the repurchase (repo) market to finance
its longer-term mortgage portfolios. Northern Rock made a similar error in
relying on short-term borrowing for its mortgage funding. The cost of insur-
ing $10 million in Bear Stearns debt for one year reached $640,000 on March
10, 2008, but dropped back to $590,000 later in the trading day. The run on
Bear Stearns reached its peak on March 13, 2008, after the firm expended $15
billion in cash reserves in order to fulfill requests by clients to withdraw their
funds. The announcement of the burgeoning liquidity crisis at Bear Stearns
and rumors of the imminent failure of that storied institution staggered Wall
Street.10 Its bankruptcy would have affected open trades with more than 5,000
other firms and 750,000 derivative contracts.
Bear Stearns was rescued through the combined efforts of the Fed and
JPMorgan Chase. The federal government feared that Bear Stearns’s failure
would spread panic through an already troubled financial system. Initially,
JPMorgan agreed to a loan arrangement under which it would make a large
collateralized loan to Bear Stearns and then borrow the same amount from the
Fed using the Bear Stearns collateral. Bear Stearns could not do that directly
because it was not a bank. This arrangement was announced to the public on
March 14, 2008, in the hope that it would stop the run on its assets. That goal
was not achieved, and Bear Stearns stock continued its plunge. The run on its
assets continued, and the firm faced bankruptcy.
On March 16, 2008, JPMorgan agreed to purchase Bear Stearns for $236
million, valuing its stock at about $2 per share, down from $170 per share in
2007.11 That sales price was compared with the fact that the top five execu-
tives at Bear Stearns earned a total of $381 million between 2004 and 2006.
As one Treasury Department official noted, JPMorgan’s price for Bear Stearns
was less than the $250 million paid by a U.S. soccer team for the services of
David Beckham. Treasury Secretary Hank Paulson had pushed for the low-
ball bid in order to prevent criticism that the government was bailing out the
shareholders.
A $30 billion loan to JPMorgan from the Fed was used to provide liquidity,
and JPMorgan agreed to be liable for the first $1 billion in losses from the
collateral. If those mortgages sustained defaults larger than that amount, the
taxpayer would bear the loss. The Bear Stearns assets used to back the bailout

from the Fed had lost about $1 billion in value at the end of June 2008, shrink-
ing most of the collateral cushion provided by JPMorgan. The value of those
securities was uncertain. BlackRock was given the job of managing the $30
billion in collateral given up by Bear Stearns and earned millions of dollars
in fees for doing so in 2009.
It was later disclosed that the Fed had lent an additional $25 billion to
Bear Stearns under its program for lending to prime dealers, which had been
instituted not long before. JPMorgan also had the option to purchase the Bear
Stearns building at a favorable price, even if the acquisition fell through, as
well as the option to buy 20 percent of Bear Stearns stock at $2 per share,
which was the same price being offered to Bear Stearns shareholders in the
buyout. Bear Stearns employees owned about 30 percent of the firm’s stock,
and they were angry and sought an alternative to this plan.
The price of Bear Stearns stock rose to $8.50 on March 18, 2008, as em-
ployees battled with bondholders over the deal with JPMorgan. In the face
of that opposition, over the Easter weekend, JPMorgan Chase raised its offer
from $2 to $10, which was accepted by the shareholders. After the JPMorgan
takeover, Cayne sold his shares in the firm for $61 million—they had once
been valued at more than $1 billion.
Bear Stearns experienced the equivalent of a run on a bank as clients
withdrew massive amounts of funds and assets on the Thursday preceding
its Sunday afternoon rescue as concern over its viability mounted. The Fed’s
rescue was motivated by the fact that firms were refusing to do business with
Bear Stearns. Counterparties in repo transactions refused to roll over Bear
Stearns’s commercial paper. If other firms might do the same, the stability
of the $4.5 trillion repo market would be endangered. After the Bear Stearns
rescue was announced, the front page of the New York Times ran the headline
“A Wall Street Domino Theory,” reflecting the fear that more rescues might
follow. The Dow Jones Industrial Average fell to 11951.09.
JPMorgan’s CEO, Jamie Dimon, was emerging as a new Colossus on Wall
Street. Dimon had protected JPMorgan from overinvolvement in the subprime
market, and the bank had weathered the credit crunch with aplomb. He advo-
cated the concept of a “fortress balance sheet” for JPMorgan, meaning that
it should be strong enough to withstand a market crisis and not have undue
risk exposure. In October 2006, after firm executives noticed that late pay-
ments were increasing on the bank’s subprime mortgages and that the cost of
credit-default swaps was rising, Dimon ordered bank personnel to reduce its
exposure to subprime debt. Over the next few months, JPMorgan sold some
$12 billion in subprime mortgages from its portfolio and ceased trading in
those products. Dimon’s rescue of Bear Stearns only added to his growing
status as a rock star. Indeed, that rescue appeared to replicate J.P. Morgan’s
rescue of the trust companies during the panic of 1907.
Dimon had been the heir apparent to Sandy Weill at Citigroup until they
quarreled over the promotion of Weill’s daughter there. Weill fired his protégé,

and Dimon left New York for the Chicago-based Bank One Corporation, the
sixth-largest bank in the United States. Dimon fostered a merger between Bank
One and JPMorgan Chase that led to his elevation as CEO of the combined
firms. He proved himself to be a successful manager, while Weill’s replacement
at Citigroup, Charles Prince, proved to be a disaster. After he took the helm,
Dimon put JPMorgan on a cost-cutting campaign and appeared to avoid the
worst pitfalls of the subprime market. Nevertheless, JPMorgan’s fourth-quarter
2007 income fell by 34 percent from the year before. The firm also took a $9.7
billion charge at the end of May 2008 for its acquisition costs relating to the
Bear Stearns takeover.
The SEC came away from the Bear Stearns debacle with little glory. The
agency conducted an investigation into how Bear Stearns priced its mortgage-
related assets in 2005, but closed the case without bringing any action. The
SEC’s inspector general, who was becoming a mini–Eliot Spitzer and a thorn
in the SEC’s side, issued a report in October 2008 criticizing a relationship
between the head of the SEC’s Miami office and a lawyer for Bear Stearns,
who was a former SEC staff member. Bear Stearns had inconsistently valued
the assets at issue in that investigation in order to avoid taking a write-off
in 2007. However, the SEC staff concluded that the amounts were not ma-
terial and closed the investigation even though Bear Stearns had proposed
a settlement. An internal report by the SEC’s inspector general concluded
that the Miami office manager had engaged in improper behavior and was
unduly close to the Bear Stearns lawyers. However, an administrative law
judge at the SEC disagreed and concluded that the staff had not engaged in
any misconduct.
The SEC inspector general issued another report on September 26, 2008,
which found that the SEC had overlooked numerous red flags on the risk
exposures of Bear Stearns. The report suggested that, if the SEC had acted in
a timely manner, the firm might have been saved. Even more embarrassing
was the fact that the SEC had announced that it was comfortable with Bear
Stearns’ positions and capital reserves just two days before that firm sought
emergency relief from the Fed.
Critics asked why the SEC was unaware of the risks encountered by the
investment banks. SEC chairman Christopher Cox asserted that the problem
was the movement of risk off the balance sheets of the investment banks,
which was exactly the problem that had surfaced at Enron. Cox was widely
criticized, including a front-page attack in the Wall Street Journal in June
2008, for his passive role during the Bear Stearns crisis. He was reported to be
absent from critical phone calls and refused to interrupt a previously planned
vacation in the Caribbean.
The Fed and the SEC concluded an agreement in July 2008 to collaborate
and to cooperate in the future. That agreement was thought necessary in light of
the disconnect between the SEC and the Fed during the Bear Stearns collapse.
Bear Stearns agreed to pay $28 million to settle charges brought by the Federal

Trade Commission over its subprime marketing practices, including unauthor-

ized fees for late payments, property inspections, and loan modifications.
On March 16, 2008, the same day that Bear Stearns was rescued, the Fed
announced that it was allowing the large investment banks to access its lend-
ing programs without any specified limit. Those investment banks were being
allowed to use their mortgage-backed securities as collateral for those loans.
The collateral deemed acceptable by the Fed under this loan program included
bonds, mortgage-backed securities, CDOs, and municipal securities. Those
instruments had to be rated investment grade by at least two rating agencies
and to have market prices to which they could be marked. The requirement
for an investment-grade rating once again underscored the importance of the
role played by the rating agencies in credit markets.
The Bush administration was accused of allowing the creation of a moral
hazard risk from its bailout of Bear Stearns, raising expectations that other
firms facing failure would also be bailed out. In the meantime, homeowners
continued to suffer from foreclosures on their mortgages without any bailout
support from the federal government. The Bush administration refused to
entertain such proposals, giving rise to criticism that the administration was
willing to protect Bear Stearns shareholders but not ordinary homeowners. In
response to that criticism, Treasury Secretary Paulson pointed out that the Bear
Stearns stockholders suffered large losses, having seen their stock price drop
to $10 a share as a result of the JPMorgan acquisition, down from a high of
$170 in 2007. In addition, the investors who had helped bail out Bear Stearns in
2007, when it was having problems with its hedge funds and mortgage losses,
had suffered badly. Joseph Lewis, a well-known financier, invested some $1
billion when Bear Stearns’s stock was trading above $100 per share and was
facing a loss of some 90 percent of his investment.
Paulson sought more concentrated regulation of investment banks. He con-
tended that, because investment banks were acting like commercial banks, they
should be subject to the same regulations as commercial banks, which would
be a blow to the SEC. In addition, Paulson wanted the rating agencies to have
their ratings distinguish between structured products and other securities, such
as municipal bonds and corporate bonds. He also pointed out that liquidity
should not be confused with creditworthiness. Better risk management was
needed on Wall Street, he said.
First-Quarter Results
The economy grew about 1 percent in the first quarter of 2008, keeping it out
of recession. Inflation also rose in the first quarter of 2008. The International
Monetary Fund (IMF) projected worldwide inflation to increase by 2.6 per-
cent during the year, the highest rate of increase since 1995. Household net
worth shrank by $1.7 trillion in the first quarter of 2008, while credit card debt
increased by 9.5 percent.

Credit scores for many Americans declined as a result of late payments on

their mortgages. Consumer debt payments increased by almost 40 percent
between 2003 and 2008, which far exceeded the 25 percent increase in dispos-
able income during that same period. Outstanding balances on home equity
lines of credit increased by 8.1 percent for the same period, and the banks
experienced increased losses from home equity loans.
The number of owner-occupied homes was still high, at 67.9 percent, in
the first quarter of 2008. Although existing home sales fell by 2 percent in
March 2008, prices appeared to stabilize. The number of loan delinquencies
continued to grow that month, but at a slower rate than in previous months.
The number of vacant homes set a new record at the end of the first quarter
in 2008, rising to 2.9 percent of all homes. This meant that 2.2 million vacant
homes were for sale. In addition, 4.1 million vacant homes were rented, with
a rental vacancy rate of 10.1 percent.
SunTrust Bank and Fifth Third Bank had problems with their loans and
wrote down large amounts after the first quarter of 2008. Bank of America
announced a 77 percent decline in earnings for the quarter. The bank took a
$1.47 billion writedown on CDOs and another $439 million to cover losses
from leveraged loans. By April 2008, Bank of America had written off $14.9
billion in bad subprime assets, and UBS had written off some $37.3 billion in
subprime mortgage loan losses. The latter posted a first-quarter 2008 loss of
$11 billion. In order to free up some cash, UBS sold $15 billion in mortgage
securities to BlackRock. The chairman of UBS, Peter Kurer, advised the
company’s shareholders in April 2008 that they faced a three-year effort to
restore the firm’s reputation.
Citigroup’s share price fell to the lowest level in almost ten years on March
4, 2008, after an analyst forecast that it would have to write down an additional
$18 billion in the first quarter. That prediction proved accurate, resulting in a
$5.1 billion loss for the firm. The bank also announced the loss of 9,000 jobs.
A credit-default swap for $10 million in Citigroup debt cost $9,700 in June
2007 but $190,000 in March 2008.
The American Federation of State, County and Municipal Employees (AF-
SCME) union declared that it sought, through its relatively small stock holding,
to have Citigroup broken up into separate investment and commercial banking
units, returning it to the days of the Glass-Steagall Act. The bank did appear
to have some serious flaws in its risk management controls and did not use its
own models to assess the risk from its CDO investments. Rather, Citigroup
relied on the rating agency to assess the risk of default on those securities.
A review of Citigroup’s risk controls by the Fed in 2008 found them woe-
fully inadequate. John C. Dugan, the comptroller of the currency, stated that
large commercial banks specializing in credit risk had no excuse for relying
solely on credit ratings in assessing risk. The risk manager for the mortgage
business at Citigroup was David C. Bushnell, a close personal friend of Ran-
dolph H. Barker, who had built up the mortgage business at Citigroup and

was paid over $15 million. Bushnell was also a friend of Thomas Maheras,
the manager of Citigroup’s fixed income business. A New York Times article
suggested that these friendships caused Bushnell to overlook concerns with
the mortgage business.12
Société Générale reported a profit for the first quarter. Although the amount
was lower than in the first quarter of the previous year, the market breathed a
sigh of relief at the absence of more major bad news from that bank. SocGen,
however, did take an additional $1.9 billion in writedowns from credit-related
losses. Credit Agricole announced a first-quarter 2008 loss and reported that
it would raise $9.1 billion in capital as a result of losses that it sustained from
investments in subprime mortgages issued in the United States. That bank also
considered selling $7.5 billion in assets. Credit Suisse had a $2.1 billion loss
in the first quarter, after writing down $5.3 billion in its investment portfolio.
It also dismissed some employees for mismarking the value of securities held
in inventory.
Barclays Bank reported a profit in the first quarter of 2008. However, it
had to write down $3.3 billion in mortgage and other credit investments. The
Royal Bank of Scotland took more than $8 billion in writedowns in the first
quarter of 2008. That bank sought to raise $24 billion in additional capital.
Deutsche Bank announced a $4.2 billion writedown for the first quarter of 2008.
Its revenues also declined sharply, resulting in a loss of almost $200 million
for the quarter. Mizuho Financial Group, a Japanese bank, lost an estimated
$5 billion from subprime mortgage investments. Nomura Holdings posted
its first fiscal year loss in nine years in April 2008, driven by $1.26 billion
in writedowns for credit-related instruments. Moody’s net profit was down
substantially in the first quarter of 2008 because so few issues were coming
to market for it to rate.
Charles Schwab was embarrassed by large losses in one of its money market
funds that had been paying high returns as a result of investments in subprime
mortgages. That fund lost 24 percent of its value in the first three months of
2008. It later paid $200 million to settle claims over those losses.
Legg Mason also had its first loss ever as a public company in the first quarter
of 2008 as a result of losses in its money market funds. One large holder of
Bear Stearns stock was the once-legendary Bill Miller’s Legg Mason Value
Trust. The value of that fund declined from $16.5 billion in 2007 to $4.3 bil-
lion in December 2008. Investors in that fund lost about 58 percent of their
investment during 2008, which wiped out all past gains of the fund and turned
it into the worst-performing mutual fund in the previous ten years. Miller had
already been dethroned in 2006 from his position of having bested the S&P
500 for fifteen years in a row. Adding insult to injury, the state of Massachu-
setts announced that it was firing Legg Mason as the investment manager for
its pension funds because of displeasure with Miller’s performance. Garrett
van Wagoner, manager of the previously worst performing actively managed
stock mutual fund, the Van Wagoner Emerging Growth fund, for the previous

ten years, resigned in August 2008. He had been a star performer before the
dot.com crash in 2000.
MF Global, the large hedge fund manager and prime broker, was under
attack. Evan Dooley, a wheat trader at MF Global, lost $141.5 million in one
day in February 2008. The firm agreed to pay the CFTC $10 million to settle
charges over that and other lapses. The price of MF Global shares dropped
by 20 percent after Dooley’s losses were reported. The company’s stock
price fell another 17 percent shortly afterward because of concern that there
might be additional losses due to rogue traders at the firm. The company’s
stock dropped a further 65 percent on March 17, 2008, after the Bear Stearns
rescue and rumors that counterparties and dealers on the street refused to do
business with MF Global.
Thrift associations lost a total of $670 million in the first quarter of 2008.
They set aside total reserves of $7.6 billion for projected losses on their loan
portfolios. By the end of the first quarter in 2008, banks and other financial
institutions had written off $215 billion in losses from subprime and Alt-A
mortgages. The loan loss reserves of U.S. banks increased by $37 billion
during the first quarter of 2008. Financial Guaranty Insurance Company was
downgraded to junk bond status at the end of March 2008. That company had
posted a loss of $1.89 billion in the fourth quarter of 2007, largely as a result of
losses from derivatives on subprime mortgages. Thornburg Mortgage posted a
$3.31 billion loss for the first quarter in 2008 and indicated that further losses
were expected.
General Motors reported a $3.25 billion loss in the first quarter of 2008. It
faced large losses from its Ditech residential mortgage unit, which had become
famous for its aggressive advertising and lending practices. Ditech offered loans
equal to 125 percent of the value of homes being mortgaged. It also allowed
no-doc loans, which became known as “liar loans” because they encouraged
borrowers to falsify their income. Ford Motor Company had $100 million
in profit for the period, but expected a loss for the rest of the year. Delta and
Northwest had a combined loss of $465 million in that quarter.
Berkshire Hathaway experienced a sharp drop in profits as a result of losses
from derivative investments. Marsh & McLennan reported a first-quarter loss
after it wrote down an investment in Kroll Associates, a high-profile private
investigation firm that was later sold for an $800 million loss. ExxonMobil
reported $10.89 billion in profit for the first quarter of 2008 as gas prices ap-
proached $4 a gallon. Agricultural companies reported huge profits in the first
quarter of 2008 as a result of the bubble in commodity prices. Corn futures
were nearly $6 dollars a bushel in April 2008, a new record. NYSE Euronext
also had a very profitable first quarter. However, exchange traded funds (ETFs)
became less popular as the stock market plunged. Their assets declined in value
by 6 percent during that quarter, to $37 billion.
The Summary of Commentary on Current Economic Conditions by Federal
Reserve District, commonly called the Fed’s Beige Book, which was made

public in March 2008, disclosed concern over weakening business activities

in various parts of the country. Housing prices fell an average of 1.7 percent
in the first quarter of 2008. The median price of a home declined by the larg-
est amount in more than forty years. New home sales fell to a sixteen-year
low, and housing starts contracted by 11.9 percent in March 2008. About
one in every eleven American mortgages, 4.8 million in all, were past due or
in foreclosure at the end of that month. Some 76,000 jobs were lost in both
January and February 2008—the largest job loss in five years—pushing the
unemployment rate to 5.1 percent, from 4.8 percent when the crisis began.
OCC head John Dugan warned in April 2008 that the country should expect
a large number of bank failures, above “historical norms.” No bank failures
had occurred between February 2004 and 2007. Fremont General Corporation
was ordered by banking regulators on March 28, 2008, to shore up its capital
as a result of losses from subprime lending. Federal banking regulators closed
ANB Financial, an Arkansas bank with assets of more than $2 billion. The
third bank to fail in the first quarter of 2008, ANB was an aggressive lender
to residential builders. It had attracted deposits by paying the highest interest
rates in the country on its certificates of deposit.
The IMF predicted in 2008 that financial services firms would lose some $1
trillion as a result of the credit crunch and the subprime crisis and that banks
would suffer losses of about half that sum. It was also forecast that the U.S.
economy would experience a downturn for the rest of the year and into 2009.
The Bank of England cut interest rates by 25 basis points on April 10, 2008.
The European Central Bank held its lending rate steady at 4 percent, the rate
set in June 2007.
More UBS Problems
UBS chairman Marcel Ospel took a 90 percent cut in pay for 2007, which
seemed appropriate because he was responsible for the business plan that had
failed so badly. He also agreed to return more than $18 million in compensation
that he had previously received. Those sacrifices did not save his job. Ospel
was fired in April 2008, and the bank later announced that all of its top execu-
tives would forgo bonuses in 2008. Some former UBS executives also agreed
to return payments that they had received on business that turned sour.
The bad news continued. In April 2008 UBS announced the write-off of
another $19 billion in subprime losses, in addition to the $18 billion previ-
ously written off. The bank also laid off 5,500 employees. It stated that it
would seek to raise more capital and to find a new chairman. Management at
UBS was restructured as its problems with subprime losses mounted and the
Justice Department focused its attentions on the UBS tax shelter programs
for wealthy Americans.
UBS raised about $12.6 billion in new capital in February 2008, but it was
not enough. UBS reported three months later that it would raise more than $15

billion through issuing discount shares. In order to free up some cash, UBS
sold $15 billion in mortgage securities to BlackRock, the company managing
the $30 billion of assets put up by Bear Stearns to the Fed in order to merge
with JPMorgan Chase.
More Losses
The Fed sent inspection teams into several large brokerage firms in April 2008
in order to monitor their financial condition. That was the first such action in
over ten years. The firms that were inspected included Goldman Sachs, Mor-
gan Stanley, Lehman Brothers, and Merrill Lynch. There was a need for such
inspections. By April 2008, Merrill Lynch had reported write-offs totaling
$31.7 billion, Morgan Stanley $12.6 billion, JPMorgan Chase $9.7 billion,
and Bank of America $14.9 billion.
The Dow Jones Industrial Average rose 256.80 points on April 16, 2008,
after several large banks reported losses that were smaller than expected. The
Dow was then at 12619.27. President Bush criticized Congress for failing to
respond to the economic problems that the country was facing as the second
quarter of 2008 began. However, a poll showed that 73 percent of Americans
disagreed with Bush’s economic policies. Candidates in the upcoming 2008
presidential election began to promote stimulus programs.
Economic Turmoil Continues
Banks continued to tighten their lending standards, making it difficult for con-
sumers to obtain loans. Nevertheless, pending home sales rose in April 2008,
leading some people to believe, erroneously, that the residential real estate
market was recovering. The supply of houses in urban markets rose again that
month, but the rate of increase appeared to be slowing. Home sales increased
4.8 percent in April, but the median price of new homes fell to $231,000 the
following month. They also rose by about 2 percent in May 2008, as prices
were slashed and bargains appeared; at the same time, however, housing starts
contracted by 3.3 percent. Housing inventories added to an eleven-month
backlog, a bleak number for that overhang on the market.
The 7 percent drop in automobile purchases pulled down indicators for
all retail sales in April 2008. Toyota Motor Corporation then passed General
Motors in quarterly automobile sales for the first time. On April 22, 2008, the
dollar set a new record low against the euro, decreasing to $1.60 per euro.
Crude oil prices reached $123.53 per barrel on May 8, 2008, and rose to
$125.80 on May 13, 2008.
Citigroup raised $4.5 billion in equity in May 2008, bringing total capital
raised over the previous six months to $40 billion. Along with other banks, it
issued preferred stock paying dividends of 8 percent in order to increase their
Tier 1 capital for regulatory purposes. Citigroup also shed assets in order to

cut losses and raise cash. Among other things, it sold $12.5 billion in leveraged
loans and sold the Citigroup Diners Club credit card business to Discover card
for $165 million in April 2008.
Two Citigroup hedge funds—Falcon Strategies and ASTA/MAT fixed
income funds, which were supposed to have been conservatively invested—
suffered massive losses in the first quarter of 2008. Citigroup volunteered to
put up $250 million to cover some of their losses. It faced another embar-
rassment in May 2008 after announcing the write-off of $202 million in
assets in its Old Lane Partners hedge fund, which it had purchased from its
CEO, Vikram Pandit, and John Havens in 2007 for $800 million. After Old
Lane began faltering, Citigroup announced plans to rescue the fund with a
contribution of $1–$3 billion. However, the bank gave up on that plan after
experiencing its own massive losses later in the year. In addition to his Old
Lane payout, Pandit received compensation as CEO of Citigroup totaling
$216 million. Pandit was criticized in a Wall Street Journal article for failing
to have clear lines of authority in place at the bank. Sheila Bair, chair of the
Federal Deposit Insurance Corporation (FDIC), began to question the quality
of Citigroup’s management.
The Bank of England announced in April 2008 a restart of bank lending by
swapping $100 billion in government bonds for securities held by banks that
were backed by mortgages and credit card debt. It pressured banks to be more
aggressive in writing down mortgage securities. The Reserve Bank of Australia
simultaneously announced its purchase of mortgage-backed securities on the
open market in order to “defrost” trading in those securities. It also accepted
residential mortgage-backed securities as collateral for loans.
The Fed began making inquiries into the London market to determine
whether the LIBOR interest rate reporting system was skewed. As described
above, that index is a popular measure for banks to use as a guide in setting
interest rates on their loans. LIBOR had risen sharply after a Wall Street Journal
article questioned whether some banks artificially lowered it when they reported
their interest charges. Apparently, the banks had been caught red-handed and
wanted to avoid further scrutiny. A Wall Street Journal investigation concluded
that Citigroup, JPMorgan Chase, UBS, and others had understated their bor-
rowing costs when reporting to the compilers of the LIBOR.
The Fed reduced interest rates by another .25 percent on April 30, 2008, in
the seventh cut in eight months. However, it indicated that it might pause on
any further rate cuts. In May 2008 the Fed sought authority from Congress to
allow it to pay interest on commercial bank reserves in order to gain further
control over interest rate levels. The credit markets seemed to recover in mid-
May 2008, but more subprime loans would reset over the next year. It was
hoped that lower interest rates would ease that payment shock.
The Treasury Department held a six-hour meeting with mortgage lenders
on May 6, 2008, in order to pressure them into streamlining their process for
restructuring delinquent loans. The default rate rose in the second quarter of

2008 in option adjustable-rate mortgages (option ARMs), which allowed the

homeowner to make very small monthly payments that did not cover interest
charges. Full payment of interest and mortgage amortization were required
if the amount of the loan increased by specific percentages as a result of
incomplete interest payments. In such event, the homeowners would face
substantially increased monthly payments. Even more troubling was the fact
that these loans were granted to borrowers with good credit ratings.
The House of Representatives passed a housing bailout bill in the second
week of May, but the president threatened to veto it, and it did not appear that
the bill, which guaranteed $300 billion in mortgages and increased regulation
of Fannie Mae, Freddie Mac, the FHLBs, and the FHA, would pass the Senate.
Critics claimed that the bill was a giveaway to Democratic supporters.
The Basel Committee on Banking Supervision in April 2008 proposed
additional measures that would require banks to adopt stronger risk man-
agement controls and improve procedures for valuing assets. Fed chairman
Bernanke, in an address in Chicago on May 15, 2008, reported, incorrectly,
that recovery seemed to be under way, but he asserted that banks still needed
to bolster their capital. By May 2008, financial firms had written off $320
billion in mortgage-related investments. Banks borrowed about $12 billion
from the Fed window, and the separate borrowing facility for primary deal-
ers lent about $18 billion at the end of April 2008. On May 2, 2008, the Fed
announced an expansion in the types of collateral that could be used to obtain
loans from its window. Assets such as credit card loans, student loans, and car
loans were added to the list of acceptable collateral. The Fed also increased
the size of its cash auctions. These actions followed the announcement that
20,000 jobs had been lost in April, the fourth month in a row of job losses.
However, that number was lower than expected, and the unemployment rate
actually fell to 5 percent.
Consumer confidence sank to a twenty-eight-year low in May 2008, but
investors appeared to be regaining confidence. The Dow Jones Industrial Aver-
age once again passed 13000 on May 1, 2008. Worries remained as consumer
spending and confidence fell. Foreclosure notices had been issued to almost
750,000 homeowners in the second quarter of 2008. Prime mortgages expe-
rienced increased default rates. JPMorgan Chase reported that 3.5 percent of
its prime mortgages were delinquent by at least thirty days, an increase of 200
percent over the previous year.
Five major mortgage lenders, including Wachovia and Washington Mutual,
reported a combined loss of more than $11 billion for the second quarter of
2008. A blog called Lender Implode-o-Meter listed 265 mortgage lenders ex-
periencing severe financial problems as a result of their residential mortgage
loans. The collapse of the housing market had other effects. Corporations
that were recruiting and relocating executives had to pay for shortfalls in the
sales prices of their homes. Qwest Communications International paid $1.8
million to cover a loss on the California home of its CEO, Edward Mueller.

It had agreed to buy Mueller’s home for $8.9 million when he was recruited,
but the company was able to sell the home for only $7.1 million.
The default rate on junk bonds and corporate bankruptcy filings reached a
five-year high in May 2008. On May 21, 2008, crude oil traded at more than
$133 per barrel. An analyst at Goldman Sachs predicted in May 2008 that
crude oil would reach $200 a barrel. Congress then called executives at the oil
companies to public hearings for explanations even though those executives
were not responsible for the market forces driving up the price of oil. The
average price of a gallon of gasoline in the United States hit $4.00 on June 6,
2008, causing consumers more anger and frustration. The average price of a
gallon of gasoline had increased by $.50 between 2005 and 2007, but now it
increased that much in only a few weeks. The Dow Jones Industrial Average
fell by 394.64 points on June 6, after crude oil prices jumped by $10 per bar-
rel, closing at $138.54.
Consumer confidence continued its downward trend at the end of June.
Home values continued to decline in many major cities. Some 10 percent of
homes built after 2000 were vacant in June 2008, and about 2.8 percent of
homes that were previously owner occupied were now vacant. The vacancy
rate for rentals reached 10 percent, the highest level since the 1950s. June 2008
was also a bad month for the stock market; it lost 10.2 percent, the largest
loss in the month of June since the Great Depression. In all, the stock market
lost $2.1 trillion in the first two quarters of 2008, of which $1.4 trillion was
lost in June alone. The job market deteriorated, approximately 62,000 jobs
evaporated in June, and the number of people unemployed for six months or
more increased substantially over the previous year. Nevertheless, the jobless
rate remained at a relatively low 5.5 percent, and the U.S. economy grew at
an annual rate of 1.9 percent in the second quarter of 2008—not great but still
out of recession territory, at least officially.
The Treasury Department and the Fed faced two daunting challenges in
international trade. A weak dollar helped exports but also fueled inflation.
At the same time, an effort by the Chinese government to keep its currency
undervalued furthered its huge trade surplus with the United States. The Fed
was talking up the dollar as a reserve currency, and Treasury Secretary Paulson
urged the Chinese government to revalue its currency. Those entreaties had
little effect. However, rising fuel costs made it more expensive to export from
China, leading some manufacturers in the United States to reopen facilities
that had been closed in favor of cheaper Chinese-made goods.
Financial Services Results
Goldman Sachs announced a profit of $2.09 billion in the second quarter of

2008, less than in the year before but still admirable in light of the turmoil in the
markets. JPMorgan Chase did better in the second quarter of 2008. Its profits
declined by less than 50 percent compared with the previous year, which was

better than forecast. JPMorgan wrote off $1.5 billion in mortgage losses but
warned that it expected further deterioration in the housing market. It reported
that its investments in Fannie Mae and Freddie Mac preferred stock had been
cut in half, losing some $600 million in value.
Bank of America reported a loss in the second quarter of 2008, but that
loss was not as bad as analysts had predicted, giving the bank a boost. It also
erroneously appeared that Countrywide Financial might return to profitability.
Banc of America Securities was sued by a group of institutional investors
who claimed that they were misled as to the assets in a $300 million offering
involving the securitization of installment sale contracts from Heilig-Meyers,
a retail company selling home furnishings. These securities had been given a
triple-A rating but their value shrank after the rating was downgraded.
Fifth Third Bank, which was formed by the combination of two national
banks that had been badly damaged by the Panic of 1907, experienced losses
in June 2008. The bank sought to raise $1 billion in capital and to sell the
same amount of assets. Its stock price was 78 percent below that of the previ-
ous year. Other regional banks also experienced sharp drops in the value of
their stock in the first half of 2008, including First Horizon National Bank,
National City Bank, Huntington Bancshares, and Regions Financial. KeyCorp,
a regional bank based in Cleveland, cut its dividend in June 2008 and sought
to raise $1.5 billion in new capital as a result of an adverse court ruling on its
tax accounting. That bank also planned to take a charge of $500 million for
nonperforming loans and faced other problems in its lending portfolio.
HSBC Holdings announced a 29 percent decline in profits for the second
quarter of 2008. Fortis, a Dutch–Belgian bank, announced in June 2008 that
it would raise an additional $13.01 billion in capital in order to cover losses
in the credit markets. Barclays planned to raise $8.86 billion in additional
capital needed to cover its losses. The Royal Bank of Scotland reported a
$1.56 billion loss for the second quarter of 2008, one of the largest losses in
history for a British bank.
UBS took another $5 billion in writedowns for the second quarter of 2008,
bringing its total writedowns during the crisis to $43 billion. The bank lost
$3.3 million in the second quarter, its fourth consecutive loss. It announced the
separation of its businesses into separate groups: banking for private clients,
asset management, and investment banking. Most of the losses at UBS were
in investment banking.
Investigations
The SEC investigated the banks and other financial services firms involved in
the subprime crisis to determine whether they had misled investors. As in the
Enron-era scandals, state attorneys general began their own investigations of
the same financial services firms being investigated by the SEC for the same
conduct. The leader was Andrew M. Cuomo, the attorney general of New York.

Richard Blumenthal in Connecticut, one of the more aggressive attorneys

general participating in prosecuting the Enron-era scandals, followed Cuomo’s
lead. Blumenthal used these investigations to garner support for a race for a
Senate seat in 2010, but was met with accusations that he had falsely claimed
to have served as a Marine in Vietnam during that conflict.
The attorneys general focused on the completeness of disclosures made by
the banks concerning the risks of the SIVs sold to investors. The attorneys
general also looked at “exception loans” packaged and sold to investors, even
though the loans did not have appropriate documentation or otherwise meet
the credit standards set by financial institutions for mortgage loans. Cuomo
also investigated the credit rating agencies in order to shine a light on any
weaknesses that might have existed in their credit assessments of mortgage-
backed securities, which generally had been given high ratings. Other targets
were “due diligence” firms that were hired by the banks to confirm the credit
information supplied by borrowers but failed to do so in any comprehensive
manner.
The City of Cleveland sued twenty-one subprime mortgage packagers,
claiming that they had devastated the city’s finances by making loans on terms
that many homeowners could not afford. The defendants included Citigroup,
Bank of America, Merrill Lynch, Countrywide Financial, and Wells Fargo,
which had packaged loans made in Cleveland, and elsewhere, into SIVs that
were then sold to investors. The banks actually making the loans in Cleveland
were not sued. The city experienced more than 14,000 foreclosures between
2006 and 2007, and the number grew in 2008. Mayor Frank G. Jackson com-
plained that entire city blocks were emptied by foreclosures and demanded
hundreds of millions of dollars in compensation for damages. This lawsuit was
brought under a state nuisance law, based on a claim that the abandoned houses
were nuisances. In the meantime, the City of Baltimore filed suit against Wells
Fargo, claiming that it violated fair housing laws by directing high-interest-rate
subprime loans to African Americans. That suit was dismissed by a federal
judge in January 2010 on the grounds that the city failed to show how lending
practices contributed to the city’s poverty.
Broadening Problems
For the first time in more than fifteen years, the eurozone economy was con-
tracting. European banks were hard-hit by the subprime crisis, reporting losses
totaling $200 billion by June 2008, while the U.S. banks wrote off $167 bil-
lion. Losses worldwide totaled $387 billion. The Fed declined to cut interest
rates any further at its meeting on June 25, 2008, leaving the Fed funds rate
at 2 percent. It was still concerned about inflation, which was at the highest
level in seventeen years at the end of the second quarter in 2008. Inflation
rose in July 2008, reaching 5.6 percent. Crude oil prices closed at $140 per
barrel on the NYMEX on June 30, 2008. Gasoline prices in the United States

were still averaging more than $4.00 a gallon, an increase of 29 percent over
the previous year.
General Motors reported a $15.5 billion loss for the second quarter of 2008,
the third-largest loss in its history. The corporation announced a reduction in
expenses of $10 billion, slashing its payroll for salaried workers by 20 percent,
stopping its dividend of $1 per share, and eliminating health care for older
salaried employees. The company faced a sharp drop in sales for small trucks
and sport utility vehicles (SUVs) as gas prices continued to climb.
The banks scrambled for funds as the credit crunch rolled on. The competi-
tion for depositor funds caused an increase in the interest rates paid on certifi-
cates of deposit (CDs). Many banks sold foreclosed homes at sharp discounts.
More than 3 million mortgages were delinquent at the end of the second quarter
in 2008. Forecasters asserted that another 2 million mortgages would fall de-
linquent in future months. The foreclosure rate on home mortgages had risen
from 1.14 percent in July 2004 to around 3 percent in August 2008.
Not a single initial public offering (IPO) of a company backed by a venture
capitalist occurred in the second quarter of 2008. The Dow Jones Industrial
Average had fallen by nearly 20 percent between October 2007 and the end of
June 2008. Crossing that 20 percent threshold would mean that a bear market
was officially under way. The Dow did fall into official bear market territory
on July 2, 2008, as the market was then down by slightly over 20 percent from
its record high in October 2007.
Short Sales
The second week of July 2008 was especially hard on the stocks of financial
services firms. Fannie Mae’s stock fell by 22 percent on July 11, 2008. In an
effort to stabilize the market, the SEC announced on July 13, 2008, that it
would crack down on the rumormongering that was undercutting the stock of
financial services firms. SEC chairman Christopher Cox announced that his
agency would conduct examinations with FINRA in order to deter the inten-
tional spreading of false information that was intended to manipulate securities
prices through false rumors and abusive short selling, in which stock was sold
into the market simply to drive down the stock price. That jawboning had no
effect. Fannie Mae’s stock fell another 27 percent on July 15, 2008.
FINRA proposed a rule to prohibit the circulation of rumors of a sensational
character that could affect market conditions and aid short-sellers. That rule
would require all members to report to FINRA the source of such rumors. It
would allow discussion of unsubstantiated information published by a widely
circulated public media. In other words, the rule would outlaw gossiping, specu-
lating, or, for that matter, thinking out loud. In England, the Financial Services
Authority recommended that financial firms adopt industry best practices to
deal with rumors through internal training, guidelines, and policies.
The SEC charged Paul S. Berliner with spreading false rumors in order

to drive down the price of Alliance Data Systems and allowing him to profit
from his short sales. He falsely claimed that a takeover of that company by
the Blackstone Group was being renegotiated down to a lower price. Berliner
had shorted the Alliance Data stock. Cuomo announced that he, too, was in-
vestigating the spreading of false rumors to aid short sales. American Tower
sued an executive at Goldman Sachs for using the e-mail address of its CEO
to send negative articles about the company to investors in order to drive
down the stock price.
The SEC had long expressed suspicion and distrust of short-sellers, who
were selling stock they did not own. For decades, that agency had imposed a
“tick” test allowing short sales only on an uptick in a stock’s price. The tick
test was adopted after a market drop in 1937 that was blamed on short-sellers.
That rule was premised on the theory that this would prevent short-sellers from
driving down stock prices through a rain of continuous short sales. However,
this rule was much criticized because it was biased in favor of the longs over
the shorts. There was thus no down tick test for stock purchasers—the “longs.”
In contrast, in the commodity markets, short-sellers are thought to be valuable
in assuring price efficiency and are subject to no special restrictions. The SEC
took a friendlier approach to short selling when it adopted Regulation SHO in
2004. In a further effort to adopt a more neutral attitude toward short-sellers,
the SEC abolished its tick test in July 2007, just in time for short-sellers to
short firms with subprime exposures.
This move away from the tick test was generally considered an advance
for the SEC in recognizing that markets may be traded on both sides—long
and short. However, the greater flexibility allowed by that rule change was
thought to have encouraged short sales and added volatility to the stock market
during the subprime crisis. As noted, concern was also raised that short-sellers
were spreading false rumors about the exposure of financial services firms
to subprime investments. Among those complaining were large investment
banks such as Lehman Brothers, Citigroup, and Bear Stearns, who claimed
that short-sellers were pulling down their stock prices.
Critics also charged that short-sellers had undermined Bear Stearns, Fannie
Mae, Freddie Mac, and AIG. Among those complaining was Jamie Dimon,
the head of JPMorgan Chase. He stated publicly that “this is even worse than
insider trading” and that it was a “deliberate and malicious destruction of
value and people’s lives.”13 Lehman Brothers accused short-sellers of trying
to drive down the price of its stock and hedge funds of acting in concert in
that effort.
As complaints mounted, the SEC criticized “naked shorts” in the press.
Short sellers do not own the stock they sell. Rather, they borrow the stock for
delivery on their sales. In closing their short position, the shorts will buy the
stock in the market and return it to the lender. Short sales are not supposed to
be made until the short has arranged for the borrowing of the stock. A “naked”
short trader sells short without having located securities for borrowing and

delivery on the short sale. The SEC received over 5,000 complaints about
naked short sales during an eighteen-month period starting January 1, 2007,
but brought no enforcement actions. The SEC did lose three cases in which
it charged that hedge funds had violated the law by covering their short sales
with restricted stock.14
On July 15, 2008, the SEC issued a temporary emergency order prohibit-
ing naked short selling in the stocks of nineteen major financial companies,
including Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, and
Morgan Stanley. This rule required brokers handling short sales to have bor-
rowed securities in their possession before conducting a short sale. The SEC
adopted an “interim final temporary rule” requiring hedge funds and other
large institutional investors to disclose their short positions on a daily basis.
They were already required to report their long positions. The SEC agreed
to delay publication of those reports so that traders’ existing positions would
not be exposed. Such exposure would have allowed other traders to attack
the shorts.
After the SEC short-sale restrictions were announced, the stocks of Fannie
Mae, Freddie Mac, and Lehman Brothers Holdings appeared, briefly, to sta-
bilize. Stocks of financial services firms even experienced a rally on July 16,
2008, after Wells Fargo reported better-than-expected results for the second
quarter. However, the share prices for Fannie Mae and Freddie Mac fell sharply
again on August 18, 2008, after concerns were renewed that a government
bailout would be necessary. Freddie Mac then announced that it was selling
$3 billion in five-year notes.
The Decline Continues
The FHA insured 23 percent of outstanding mortgages insured in July 2008,

compared with 1.8 percent in 2006. The stock prices of financial companies
were hammered again as the third quarter of 2008 began. At those lower prices,
their dividend returns became quite extraordinary, but declines in those stocks
continued. IPOs fell to a five-year low worldwide in July 2008. The volume
of merger and acquisition activity in the first half of 2008 was 35 percent
smaller than that of the first two quarters of 2007, a decline attributed to the
continuing credit crunch.
Jobless claims rose to 455,000 at the end of July 2008, pushing the unem-
ployment rate to 5.7 percent, the highest level in six years, and the seventh
straight month of job losses. The federal budget deficit reached a record $311
billion in the first half of fiscal year 2008. A lagging economy resulted in a
$40 billion shortfall in revenue for the states as a result of diminished tax
collections.
The Fed extended its lending program providing access to its discount win-
dow to financial services firms beyond the traditional group of prime dealers
given access to that facility, but the use of the facility was declining. About

$1.7 billion in borrowing on that facility was outstanding in the first week of
July, down from $38.1 billion in April. The Fed, nevertheless, believed that
extending the facility would lend more confidence to the market. This facility
also allowed the Fed to broaden its regulation of the investment banks that
qualified as prime dealers, and it stationed staff at those investment banks.
President Bush tried to reassure the public on July 15, 2008, that FDIC in-
surance would protect their bank deposits. On the same day, Bernanke testified
before Congress that things were looking bleak for the economy. Democrats
sought another stimulus package that would include funds for building and
repairing infrastructure, including roads and bridges.
The Dow closed below 11000 on July 15, 2008, for the first time in two
years, but that index rallied to 11,446.661 on July 17, 2008, as the price of
crude oil fell to $130 per barrel. A housing sector index indicated that home
prices fell more than expected in July 2008. The banks tightened their lending
standards in 2008, even for conventional mortgages, making it more difficult
for consumers to buy houses.
In July 2008, the number of existing home sales unexpectedly increased by
3.1 percent. However, existing inventories continue to increase, and prices were
lower as a result of distress sales. Banks added fees onto the new FHA jumbo
loans. The banks asserted that the higher fees were needed because it was diffi-
cult to securitize the larger loans. The FHA, Fannie Mae, and Freddie Mac loan
limits had been doubled, from $362,790 to $729,750. However, that increase
was in effect only until year-end 2008, when the ceiling declined to $625,500
in high-cost areas of the United States and $417,000 in other areas.
The European Central Bank, inexplicably, raised interest rates in July 2008
by 0.25 percent, pushing its interbank rate to 4.25 percent. Alistair Darling,
the British chancellor of the exchequer, announced in July 2008 that the Bank
of England’s role was being restructured. A new “Financial Stability Com-
mittee” was created to monitor the British financial system. It would draw
on the expertise of industry members. This action was taken in response to
criticism that the Bank of England was out of touch with developments in
the financial markets. The board of directors at the Bank of England was
also reduced from eighteen members to twelve and included more members
with industry expertise. The Financial Services Authority (FSA), the UK’s
financial regulator, was given additional power to act in emergencies, as when
a bank was failing.
In the summer of 2008, Treasury Secretary Paulson promoted the use of
“covered” mortgages, or mortgaged-backed securities secured by mortgages
issued by the originating bank. Unlike with most CDOs, the originating bank
keeps the covered mortgages on its own balance sheet, thereby giving it an
incentive to make only sound mortgages. Four major banks agreed to par-
ticipate in this program: Bank of America, JPMorgan Chase, Citigroup, and
Wells Fargo.
The FASB announced in July 2008 that it would delay, for one year, a

proposed accounting standard change that would require banks and other
institutions to bring onto their balance sheets instruments such as mortgage-
backed securities. There was concern that imposing this requirement while
the crisis was still under way would further devastate the stock prices and
financial conditions of those firms. The changes would have had a particu-
larly adverse effect on Fannie Mae and Freddie Mac. The Financial Stability
Forum, an international group of regulators, considered in June 2008 whether
to impose capital charges that would make it more difficult and expensive
for investment banks to hold large amounts of mortgage-backed securities.
In any event, banks dumped their mortgage portfolios in June 2008, at sharp
discounts averaging $.60 on the dollar and with some discounts as low as
$.20 on the dollar.
IndyMac Fails
Bank stocks fell in price by 45 percent between October 2007 and August
2008. The First Priority Bank in Florida closed in August 2008. Regulators
also seized the First National Bank in Nevada and the First Heritage Bank
in Newport Beach, California, in July 2008. An even larger failure was in
progress at IndyMac Bancorp (IndyMac), a large residential mortgage lender
founded by Angelo Mozilo and David S. Loeb, who were also the founders
of Countrywide Financial Corporation. IndyMac had begun as Countrywide
Mortgage Investment in 1985 and was spun off as an independent banking
operation in 1997. Countrywide and IndyMac then became competitors.
Mozilo ran Countrywide, and Loeb ran IndyMac until he retired in 2003, just
before his death.
IndyMac had total assets of $32 billion, as of March 31, 2008. It had thirty-
three retail branch offices, all located in Southern California, and 7,200 employ-
ees. IndyMac was among the top ten mortgage lenders in the United States. It
was the largest savings and loan in Los Angeles County and the fifteenth largest
in the country based on the volume of assets. IndyMac specialized in Alt-A
mortgages, a grade above subprime. However, many of IndyMac’s mortgages
were low-doc and no-doc, or “liar” loans, and many of those loans became
delinquent or went into foreclosure as the subprime crisis emerged. IndyMac
also suffered badly from the slump in the residential mortgage market, which
sharply reduced its loan originations.
The firm could not securitize its mortgage originations in late 2007 because
of the decline in the secondary market for nonagency mortgage loans that
were not guaranteed by a GSE like Fannie Mae. IndyMac designated $11.9
billion in single-family loans as “held for investment,” including $3.4 billion
in pay-option ARMs that allowed borrowers to choose to pay only interest
and $4.9 billion in interest-only mortgages. If held for investment, the loans
did not need to be marked to market. IndyMac serviced a further $184 billion
in mortgages for other mortgage originators.

About one-third of IndyMac’s deposits were brokered deposits. Deposit

inflows at IndyMac in the three days leading up to June 27, 2008, were $31.2
million. A deposit run began at IndyMac on June 27, 2008, as a result of a
letter from Senator Schumer, which is described below and which indicated
that IndyMac was failing. Deposit outflows between June 27, 2008, and July
7, 2008, were $730.2 million and $1.3 billion through July 10.
To meet its liquidity needs IndyMac received FHLB advances of $10.1 bil-
lion as of June 30, 2008. It tried unsuccessfully to change its business model
to become a sponsor of mortgage originations for Fannie Mae and Freddie
Mac. In July 2008 IndyMac announced the discontinuation of its mortgage
business and a reduction in its workforce of about 50 percent, or nearly 3,800
jobs. That action came too late to save the bank, which failed on July 11, 2008,
and was seized by federal regulators in the third-largest bank failure in U.S.
history, behind Continental Illinois National Bank and Trust, which failed in
1984, and the American Savings & Loan Association in Stockton, California,
which failed in 1988.
As noted, the run on IndyMac’s deposits followed the release of a letter from
Senator Charles Schumer (D-NY), who headed a key Senate banking subcom-
mittee, to the FDIC and Office of Thrift Supervision (OTS) on June 26, 2008,
in which he questioned the solvency of IndyMac. John Reich, the director of
the OTS, later blamed IndyMac’s failure on the letter. After the bank closed, a
group of employees petitioned Jerry Brown, the attorney general of California,
to investigate Schumer’s actions. Brown, a Democrat, refused to do so. It also
turned out that, at the time the letter was sent, some Democratic supporters had
been seeking to acquire assets of IndyMac in the event of its failure.
The OTS also came under criticism after it was discovered that it had
allowed IndyMac retroactively to book a capital infusion of $18 million
from its parent company on May 9, 2008. The bank was allowed to treat that
capital infusion as if it had been made on March 31. Otherwise, it would
have lost its status as a “well-capitalized” bank, which would have restricted
its ability to obtain deposits from deposit brokers, the principal source of
its deposits. The amount of the capital shortfall was small, and it was due
to an accounting error, but the OTS had facilitated backdating of capital
infusions in five other cases, a practice that SEC accounting rules prohibit
for other public companies.
A study by the Treasury Department concluded that the OTS had ignored
warnings that IndyMac had accumulated a large quantity of poor-quality mort-
gages and did not verify the income of borrowers. The OTS was also aware
that IndyMac pursued an overly aggressive growth strategy that was funded
by costly brokered deposits, becoming a factor in a subsequent congressional
determination to eliminate that agency. The FDIC advised homeowners who
were delinquent in repaying IndyMac loans that they could refinance on better
terms, so that they would not have to lose their homes. Within two months,
some 3,500 IndyMac mortgages had been renegotiated by the FDIC. The FDIC

later sued four Indymac executives seeking $300 million in damages for mak-
ing loans to home builders with little likelihood of repayment.
A group of private equity investors—including George Soros, Christopher
Flowers, John Paulson, Dune Capital Management, some former Goldman
Sachs executives, and Michael Dell of Dell Computers—bought the remnants
of IndyMac from the FDIC in December 2008. The FDIC was represented
in the sale by a group of former Lehman Brothers investment bankers. The
private investors agreed to contribute $1.3 billion in capital for that purchase
and changed the bank’s name to OneWest Bank. That entity later acquired
another failed bank, First Federal Bank of California, making it the largest
bank based in Southern California with total assets of $24 billion.
The purchase of IndyMac represented a sea change in regulation. Large
investments in banks by private equity groups had been opposed by the Ser-
vice Employees International Union (SEIU), which argued that the private
equity firms would unduly leverage the banks and would not make what the
union believed to be socially responsible loans. Previously, regulators had
not permitted private equity groups to take more than 24.9 percent of a bank
unless they registered as a bank holding company. Private equity groups did
not want to become bank holding companies because of the restrictions that
regulation would place on their investment activities.
Energy Prices
One of the largest energy companies, BP, would become the center of a num-
ber of controversies that are described below and which culminated in the
giant oil spill in the Gulf of Mexico in 2010. The first of these contretemps
involved a high-profile battle between BP and a group of Russian investors in
a joint venture called TNK-BP, which was created to exploit energy resources
in Russia. The Russian government began a campaign of harassment against
Robert Dudley, the BP CEO for the project and who was later made the CEO
of all of BP during the Gulf oil spill. Dudley was forced to leave the country
after the Russian government refused to extend his work visa. A Russian court
later upheld that action. That exit was followed by the resignation of James
Owen, the BP CFO for the venture. BP was forced to recall 148 employees
from Russia. Russian authorities also threatened BP with tax prosecutions in
a further effort to force BP out of the project. The pain was eased for BP by
an 83 percent increase in profits in the third quarter of 2008.
As a rational response to skyrocketing gas prices, Americans cut back their
consumption of gasoline, leading to a decline in petroleum imports of 10.5
percent in May 2008 and in July 2008 imports fell to the lowest level in five
years. However, the price of crude oil continued to rise, reaching $145.80
a barrel on July 11. The alarming spike in crude oil prices set off full-scale
congressional investigations into the reasons. More than forty congressional
hearings were held on the extent of “excessive speculation” in the energy

markets.15 However, a large percentage of Americans wanted more drilling,

and the whole matter became a political hot button until prices began to fall.
The BP Gulf oil spill also redirected support of offshore drilling from support
to widespread opposition.
In the meantime, the Commodity Futures Trading Commission (CFTC) was
under fire for failing to attack speculators. In an effort to satisfy its critics, the
CFTC charged several defendants with manipulating crude oil prices on the
NYMEX. The CFTC and the Justice Department also investigated other energy
traders. The bubble in commodity prices appeared to deflate by August 2008
when fundamentals reasserted themselves as supply increased and demand de-
creased. Crude oil prices declined to $113.77 a barrel on August 15, 2008.
Federal Housing Administration
After a default occurs on an FHA-insured mortgage, the FHA pays a lender

the unpaid mortgage balance and interest as well as foreclosure costs and other
expenses. The Department of Housing and Urban Development (HUD) then
receives the titles to foreclosed properties and disposes of them. As the twen-
tieth century ended, HUD had some 30,000 properties in its inventory from
defaulted mortgages. Between 2007 and 2008, however, more than 100,000
additional units were foreclosed by HUD.
The FHA insured 4.8 million single-family residential mortgages and 13,000
multifamily developments in 2008. Almost 80 percent of its loans went to
first-time homebuyers and about 31 percent to minorities. The FHA advocated
a risk-based pricing system in 2007 that would have charged borrowers insur-
ance premiums based on their risk of default. The agency was concerned about
“adverse selection,” that is, private lenders pursued the lower-risk borrowers in
the FHA’s market, leaving the FHA with the most risky loans. That risk-based
premium program went into effect in July 2008, but it was suspended a few
months later as the subprime crisis worsened.
Mortgage insurance was also used for non-FHA guaranteed loans. Private
lenders usually required mortgage insurance when a down payment was less
than 20 percent of the home value because foreclosure rates were higher in
this situation. Although the amount of the premium payments for such credit
insurance was sometimes predatory, credit insurance was a necessary element
in subprime lending because of the high default rate. In 2002, for example,
subprime loans defaulted at a rate five times that of conventional prime loans.
A mortgage is typically considered in default when the borrower misses three
consecutive monthly payments and a fourth payment is due.
As in the 1930s, the high rate of foreclosures during the subprime crisis led
to continuing calls for mortgage restructuring that would allow homeowners
to remain in their homes. Some mortgage holders voluntarily modified their
mortgages. However, a government report found that more than a third of
the mortgages that were modified in the first quarter of 2008 were delinquent

again after six months. Voluntary modifications were made for 2.8 million
loans during 2008. One continuing barrier to modification was the fact that
many subprime mortgages had been securitized, and it was necessary in many
instances to obtain permission for such modifications from the purchasers of
the interests in those pools. That permission was not always willingly given.
On July 30, 2008, despite having threatened a veto, President Bush signed
into law the Housing and Economic Recovery Act of 2008. The legislation
contained a $300 million bailout plan for homeowners with mortgages fac-
ing foreclosure, called Hope for Homeowners. It allowed the FHA to insure
up to $300 billion in new refinanced mortgages, which would allow some
400,000 homeowners to refinance on more favorable terms by converting to
government-guaranteed mortgages. However, the institutions underwriting
the original loans would have to forgive some of the principal because the
refinanced mortgages could not have a loan-to-value ratio of more than 90
percent. Doing so would require the lender to reduce the amount of the mort-
gage to that level. Because housing prices were falling rapidly, that could call
for a significant write-off.
By the end of the year only 357 individuals had signed up for this voluntary
program, and by February 2009 only a handful of homeowners had received
any relief under the program. HUD blamed the small number of applications
on high fees and restricted eligibility requirements. Another program, called
FHASecure, was developed to provide relief to some 80,000 homeowners who
were delinquent on mortgages with adjustable interest rate resets. However,
that program provided relief to only 4,100 homeowners, and the program
ceased at the end of December 2008.
The Wall Street Journal published an article in July by James Grant head-
lined “Why No Outrage?” He questioned why populism had not created more
anger among the general public as the subprime crisis deepened.16 Grant was
particularly surprised at the dearth of public outrage at the losses borne by
financial services firms. Actually, a populist movement was gathering steam
that resulted in the election of President Barack Obama and turned into a
wildfire in 2009, at the very bottom of the crisis, and after the disclosure of
large bonuses given to executives of failed financial services firms.
The stock market was in a panicky mood, as demonstrated by its reaction
to a false report that United Airlines was returning to bankruptcy. After that
report surfaced on the Internet, the airline’s stock price fell to $.01, a decrease
of 99.9 percent. The Internet report was actually a reprint of a six-year-old
story in the Chicago Tribune that was reporting on a 2002 bankruptcy filing
by the airline, which had been resolved. But some real current problems did
exist. Corporate bond offerings in August 2008 paid the highest rates since
the recession in the early 1990s. The unemployment rate hit 6.1 percent in
August 2008, a five-year high.
The rate of mortgage delinquencies increased in August 2008, as did fore-
closure rates. More than 6.6 percent of mortgages were delinquent at the end

of that month, compared with 4.51 percent in the previous year. The percent-
age of one-to-four family residences in foreclosure or delinquent rose to 9.16
percent during that month. About 30 percent of all subprime loans were in
foreclosure or delinquent, compared with 5.35 percent of prime loans. Appar-
ently still clueless about the oncoming crisis, Fed chairman Bernanke stated on
August 22, 2008, that he was more optimistic about the possibility of inflation
because of a decline in oil prices and weak growth.
WCI Communities, a real estate builder based in Florida, declared bank-
ruptcy on August 5, 2008. A leading builder of luxury homes and residential
towers, WCI had been in business for more than fifty years and had operations
in seven states. It lost $578 million in 2007. Unable to service its $1.8 billion
in debt, the company defaulted on some of its loans in the second quarter of
2008. WCI declared bankruptcy after creditors refused to restructure those
loans. Carl Icahn, the ruthless corporate raider, lost his $126 million invest-
ment in WCI. He had tried to take over the entire company in 2007 with an
offer of $22 per share, but the company rejected that offer. Within a year, the
WCI stock was worthless.
Five large credit unions showed marked-to-market losses on their mortgage
loans in August 2008, raising concerns that the contagion had spread to this
normally very conservative lending market. Credit card companies wrote off
some $20 billion in bad credit card debt in the first six months of 2008—about
5.5 percent of outstanding credit card debt, but still under the 7.9 percent
default rate in 2001. Chrysler Financial failed to raise all of the $30 billion in
short-term debt it needed in the first week of August 2008.
Consumer credit contracted in August 2008, for the first time in ten years.
Securitized credit card receivables had difficulties with investors who were
wary of those investments because of increasing delinquencies. The number
of individual investors fell to a record low in August 2008. Their share of the
market fell to 24 percent, with institutions holding the remainder. Individuals
had owned 94 percent of stock in 1950, 63 percent in 1980, and 34 percent
at the end of 2006.
Third-Quarter Results
The market for IPOs was virtually dead at the end of the third quarter of 2008.
No offering had been made during the quarter since early August. Initial
estimates concluded that the U.S. economy had shrunk by 0.3 percent in the
third quarter of 2008, the worst result in seven years. However, revised figures
released in November for the third quarter showed that the gross domestic
product (GDP) had actually contracted by 0.5 percent on an annual basis.
Productivity also slowed in the third quarter.
Existing home sales increased by 1.4 percent in September 2008 as a result
of fire sales of foreclosed homes by banks. Regional banks in the United States
posted some large third-quarter losses, raising concerns about their future vi-

ability. The Credit Suisse Group experienced a loss of $1 billion for the third
quarter of 2008, after taking $2.09 billion in writedowns on mortgage securities
and unsold leveraged loans. Germany’s second-largest bank, Commerzbank,
had a third-quarter loss of more than $350 million and received a $10.4 billion
injection of capital from the German government. Another German bank, HSH
Nordbank, was given a $45 billion guarantee from the German government
to stabilize its condition after warning of an expected loss of more than $500
million for the third quarter.
Société Générale also had a bad third quarter after more writedowns, but
was able to show a profit. HSBC reported nonperforming loans totaling $4.3
billion in the third quarter of 2008. It had modified mortgage loan terms for
almost 240,000 mortgages with total value of $28.8 billion. However, the
bank was being required to make further concessions because homeowners
continued to fall behind on their mortgage payments.
Man Group reported a sharp increase in earnings for the third quarter of
2008, but the price of its shares fell by 31 percent. Swiss Re announced a
third-quarter loss of $258 million and suspended its massive stock buyback
program. The losses were attributed to credit-default swaps and increased
claims due to hurricanes. The Hartford Financial Services Group had a $2.6
billion loss for the third quarter of 2008 and had received a $2.5 billion capital
investment in October from the German insurance company Allianz. MetLife
had a third-quarter loss of $1.03 billion and raised $2.3 billion in a public of-
fering. Prudential Financial reported a third-quarter loss of $166 million. ING
Group posted its first-ever quarterly loss in the third quarter of 2008, having
lost about $600 million. Zürich Financial reported a 90 percent decline in
profits in the third quarter.
Home Depot’s earnings in the third quarter of 2008 fell by 31 percent.
Lowe’s experienced a 24 percent decline in earnings for the quarter. Target
also had a 24 percent decline as credit card defaults increased. In contrast, Wal-
Mart announced an increase in profits of 9.8 percent in the third quarter. Some
public companies used their employee pension plans to fund large benefits for
executives totaling hundreds of millions of dollars, including Intel.
Fannie Mae and Freddie Mac Are Nationalized
Fannie Mae and Freddie Mac were in a death spiral. Their problems had started
emerging early in the year and grew worse as the market lost confidence
in their ability to survive. Peter Wallison, a senior fellow at the American
Enterprise Institute, had been raising concerns over the financial viability of
Fannie Mae and Freddie Mac, and the systemic threat they posed, for more
than twenty-five years. His warnings were justified but were ignored. The debt
and mortgage guarantees of these GSEs were said to have the implicit backing
of the government. Although the government had warned that there was no
explicit guarantee, each GSE had a backup line of credit from the Treasury of

$2.25 billion. Moreover, if these GSEs failed, they would wreck the economy,
which meant that they were too big to be allowed to fail.
GSEs originated 81 percent and Fannie Mae alone originated 50 percent
of all mortgages in the fourth quarter of 2007. Together they then held some
$6 trillion in mortgages that they owned or were guaranteeing, representing
more than 40 percent of the U.S. housing market, in 2008.
Freddie Mac reported a $151 million loss in the first quarter of 2008. That
loss would have been much worse but for some accounting manipulations.
Fannie Mae reported a loss for the first quarter of $2.2 billion. In order to shore
up these institutions, the Federal Housing Finance Board had announced in
March 2008 that it would allow the FHLBs to increase their holdings of Fan-
nie Mae and Freddie Mac securities by more than $100 billion. The FHLBs
also extended loans of nearly $1 trillion to their members, which included
Countrywide Financial and Washington Mutual.17
On March 19, 2008, the Office of Federal Housing Enterprise Oversight
(OFHEO) eased the stiffer capital requirements that had been imposed on
Fannie Mae and Freddie Mac as a result of their accounting problems. This
change allowed them to invest in additional mortgages valued at $200 billion.
Another cloud was seemingly lifted when Freddie Mac settled a shareholder
class action, which was brought over its accounting manipulations, for $410
million, at the time the eighth-largest settlement in a securities fraud case.
A settlement was also reached with Franklin Raines and other executives at
Fannie Mae who led that enterprise while it was massively manipulating its
accounts. The settlements were for nominal amounts. Raines agreed to donate
about $2 million to charity and to give up some worthless options that he had
been granted while at Fannie Mae. He also agreed to relinquish $5.3 million
in “other benefits.”
Concerns were renewed after Standard & Poor’s warned in April 2008 that
the U.S. government could lose its triple-A rating if it was forced to rescue
Fannie Mae and Freddie Mac. That claim would be tested in future months.
OFHEO warned in April 2008 that, while Fannie Mae and Freddie Mac had
made improvements in their systems and operations, they still were of “sig-
nificant supervisory concern.” Although it had eased their capital requirements
only two months earlier, OFHEO advised Congress in May 2008 that Fannie
Mae and Freddie Mac’s capital was insufficient for the risks that they faced and
that taxpayers could be left footing a big bill. Interestingly, Freddie Mac an-
nounced on March 13, 2008, that it would not be seeking additional capital.
More concern was raised on May 6, 2008, after the New York Times pub-
lished a front-page article questioning whether Fannie Mae and Freddie Mac
would be endangered by the growing problems in the mortgage market. The
article pointed out that those two GSEs combined were handling more than 80
percent of all mortgages sold to investors in the first quarter of 2008—twice
the share of such sales in 2006.18 To counter concerns over its financial stabil-
ity, Fannie Mae announced that it was raising $6 billion in additional capital.

This was in addition to the $7 billion that it raised in December 2007 through
the sale of preferred stock. That did not stabilize the situation.
The price of Freddie Mac and Fannie Mae’s shares fell to a fourteen-year
low on July 7, 2008. On July 10, 2008, the government announced that Freddie
Mac was technically insolvent and that Fannie Mae would be so shortly. The
New York Times reported on July 11, 2008, that the Bush administration was
considering a takeover of Fannie Mae and Freddie Mac because the decline in
their stock values was making it difficult for them to raise more capital. Also,
concerns were expressed that they faced additional losses from their mortgage
holdings. More turmoil arrived after Treasury Secretary Paulson announced
that any losses by the GSEs would have to be borne by shareholders before
the government would step in to rescue creditors.
An emergency meeting was held on July 13, 2008, by officials at the Fed
and the Treasury Department to prepare a rescue plan for Freddie Mac and
Fannie Mae. That meeting closed with a recommendation for legislation that
would allow the federal government to inject Fannie Mae and Freddie Mac
with billions of dollars of capital if they were not able to raise funds in the
capital markets. The current line of credit available to these entities was in-
creased to $300 billion. An interim credit facility would be made available at
the Federal Reserve Bank of New York in the event of a liquidity emergency.
In their testimony before a congressional committee a few days before this
emergency meeting, Paulson and Fed chairman Bernanke gave the impres-
sion that the economy and financial system were on the mend, although they
agreed that further losses could be expected. However, Paulson had instructed
his staff a few weeks earlier to begin planning for a rescue of Fannie Mae and
Freddie Mac.
The Housing and Economic Recovery Act, signed into law at the end of
July 2008, created a new federal agency, the Federal Housing Finance Agency,
to regulate Fannie Mae and Freddie Mac and the twelve Federal Home Loan
Banks (FHLBs). This new agency assumed the responsibilities of OFHEO
and the Federal Housing Finance Board. That legislation further authorized
an unlimited credit line to Fannie Mae, Freddie Mac, and the FHLBs. The
Treasury Department could also purchase stock in Freddie Mac and Fannie
Mae in order to support their capital.
These measures did not stop the hemorrhaging. On August 6, Freddie
Mac reported a second-quarter loss of $820 million, which was much more
than had been predicted by analysts. It also warned that more losses would
be forthcoming in the second half of the year. That news was followed by a
loss of $2.3 billion at Fannie Mae, which thereupon announced that it would
reduce the amount of its mortgage purchases, in another setback for the hous-
ing market.
On August 10, Paulson stated that he did not plan to inject Fannie Mae and
Freddie Mac with any capital, but less than a month later, on September 8,
2008, the Treasury Department seized control of both GSEs. They were placed

in conservatorship, and their executives were replaced. James Lockhart, the

head of the newly created Federal Housing Finance Agency, was given control
over both agencies. At this point, Fannie Mae and Freddie Mac had suffered
more than $14 billion in losses in 2008, and their stock values had fallen more
than 90 percent. Although Freddie Mac and Fannie Mae had failed, Farmer
Mac was profitable, and the price of its shares increased 153 percent as the
third quarter of 2008 began.
The Treasury Department created a new secured lending credit facility
available for Fannie Mae and Freddie Mac. Loans from that facility were to be
collateralized by mortgage-backed securities issued by Freddie Mac or Fannie
Mae or advances made by the FHLBs. Fannie Mae was also easily able to sell
$7 billion in two-year notes after it was placed into conservatorship because of
the government backing. The Treasury Department further agreed to purchase
up to $100 billion in senior preferred stock in both Fannie Mae and Freddie
Mac and to provide up to $200 billion in capital to support their obligations.
In exchange, it was given $1 billion in preferred stock in both Fannie Mae and
Freddie Mac. The Treasury Department also took warrants that entitled it to
purchase 79.9 percent of the common stock of each company.
The seizure of Fannie Mae and Freddie Mac set off default triggers in credit-
default obligations written on those two entities. However, such payments
were limited because of the government’s seizure and backing of them. What
was not measurable was what would have occurred if the government had not
backed the GSEs after they failed. In any event, the stock market rallied after
their seizure. However, Fannie Mae lost $29 billion in the third quarter of
2008 and announced that it expected further losses before year-end, possibly
requiring a large cash infusion from the government. There was also a new
storm brewing over at Lehman Brothers.

12. The Great Panic Begins
The Financial Hurricane
Lehman Brothers
Lehman Brothers experienced the world’s largest bankruptcy ever on Septem-

ber 15, 2008, wresting that title from WorldCom. Its failure sent shock waves
across Wall Street and nearly brought down the entire economy. Lehman
Brothers was another victim of a liquidity crisis engendered by a run on its
assets, as rumors continued to circulate over the firm’s deteriorating financial
condition. Even though it had arranged a bailout for Bear Stearns, the federal
government refused to do so for Lehman Brothers.
Lehman Brothers was no fly-by-night outfit. Founded in 1850 as an Alabama
cotton broker, the firm moved its operations to New York after the Civil War and
prospered for many years until the 1970s, when it nearly went bankrupt in the
wake of the paperwork crisis that toppled a number of brokerage firms because
their systems could not handle an unexpected increase in trading volume. It
then merged with the investment bank Kuhn Loeb in 1977, after rejecting a
merger offer from the ubiquitous Sandy Weill, who was then the head of the
securities firm Shearson Hayden Stone. Peter G. Peterson, who had served as
commerce secretary under the Nixon administration (1972–73), subsequently
joined Lehman, bringing it back to profitability.1 Peterson went on to found the
Blackstone private equity group along with Stephen A. Schwarzman, another
former Lehman Brothers executive.
Lehman Brothers faced another crisis in 1984 and was acquired for $360
million by Shearson/American Express, where Sandy Weill was working. The
combined firm experienced still another financial crisis in 1990, losing nearly
$1 billion in a single quarter, but it recovered. However, Lehman Brothers was
spun off from American Express in 1994, and Richard S. Fuld became its chair-
man and CEO. His goal was build the firm into a Wall Street powerhouse that
would challenge Goldman Sachs for primacy as an investment banking firm.
Fuld had to overcome some challenges in seeking to reach that goal. Lehman
Brothers ran into a severe liquidity crisis in 1998, after it experienced difficulty
524

The Great Panic Begins 525
in rolling over its commercial paper and repurchase agreements (repos). This
was because rumors were circulating that the firm had sustained large losses
in the market turmoil that followed an economic crisis in Asia and Russia and
the collapse of a large hedge fund, Long Term Capital Management. Lehman
Brothers’ counterparties demanded more collateral and higher interest rates,
straining Lehman’s highly leveraged capital. Fuld blamed the rumors on trad-
ers at Goldman Sachs and other competitors, and he was able to convince the
New York Stock Exchange (NYSE) to announce that Lehman Brothers was
financially healthy. This helped to dampen the run on the firm.
Lehman Brothers recovered from that setback, and Fuld resumed his ef-
fort to challenge Goldman Sachs. That goal seemed to be in sight as Lehman
Brothers sought to take advantage of the real estate bubble. It vastly expanded
its commercial real estate activities and entered the subprime market through
its acquisition of BNC Mortgage in 2003. Lehman expanded its mortgage-
backed holdings from about $39 billion in 2003 to more than $111 billion in
2006. The firm reported impressive earnings in 2006 and continued with record
profits in 2007. Lehman Brothers was ranked as the “Most Admired Securities
Firm” by Fortune magazine in 2007 and was voted number one in both equity
and fixed income research by Institutional Investor’s “All-America Research”
polls for the fifth consecutive year. However, the firm showed some strains
from exposure to subprime investments, resulting in some write-offs.
In a press release issued by Lehman to announce its fourth-quarter 2007
results, Fuld stated,
Despite what continues to be a difficult operating environment, the Firm’s results for
the quarter highlight our ability to perform across market cycles and deliver value
to our shareholders. Our global franchise and brand have never been stronger, and
our record results for the year reflect the continued diversified growth of our busi-
nesses. As always, our people remain committed to managing risk and providing
the best solutions to our clients.2
Lehman Brothers announced its departure from the wholesale mortgage market
because of the continuing slump in housing sales and the elimination of jobs
devoted to that business.
The firm came under attack in 2008 over concerns that its business model
was very close to that of Bear Stearns. Lehman’s stock price fell by 19 percent
on March 17, 2008, the day after the Bear Stearns collapse, closing that day
at $31.75, down from $82 a share in the previous year. Lehman Brothers had
some $700 billion in assets and liabilities that was supported only by capital of
$25 billion. Most of its assets were long-term, while most of its liabilities were
short term. Lehman Brothers funded its operations through short-term repo
transactions that required it to borrow on a daily basis tens and even hundreds
of billions of dollars through repos. This meant that, if repo counterparties lost
faith in Lehman Brothers and refused to rollover their repos, Lehman Brothers
would have to cease business.

Lehman Brothers raised $4 billion in March 2008 through preferred stock

sales in order to shore up its capital position. However, concern continued
over Lehman’s exposure to subprime mortgages. Lehman was also ensnarled
in litigation over its sale of collateralized debt obligations (CDOs) in Australia,
where only about 1 percent of its mortgage loans were subprime. However,
some Australian institutions bought U.S. subprime securities.
More concerns were raised in April 2008, after Lehman Brothers liquidated
two of its money market funds. The firm, nevertheless, reported a first-quarter
gain of $1.1 billion. Those earnings were better than expected, although they
were lower than the previous year. Lehman Brothers also disclosed its capital
position in order to reassure the market that it was not on the ropes or suf-
fering from mortgage losses that would make it in any way comparable to
Bear Stearns. That good work was undone, however, after Lehman Brothers
reported an unexpected loss of $2.8 billion for the second quarter, the largest
loss in the firm’s history and Lehman’s first quarterly loss since 1994. The
loss was mainly the result of two large real estate investments that turned
sour. Lehman raised an additional $6 billion in capital in June 2008 in order
to cover its second-quarter losses and restore its balance sheet. Among those
investing in that stock issuance were the New Jersey state pension funds and
Hank Greenberg of American International Group (AIG).
Fuld replaced two senior executives after this loss: his lifelong friend
Joseph M. Gregory, the firm’s president, and Erin Callan, the firm’s chief
financial officer (CFO). Callan had aggressively denied reports that Lehman
Brothers faced massive losses from commercial real estate investments. Actu-
ally, Lehman had $29 billion in real estate exposure on its books, largely as
a result of a bridge equity program, a program in which the firm invested its
own money in real estate deals that it was financing. Lehman’s commercial
real estate exposure grew under the management of Mark Walsh, the head of
Lehman’s global real estate unit. Fuld was forced to fire Gregory after a revolt
by other senior managers over his management style, who then tried to reduce
the firm’s exposures.
Lehman Brothers sought to reduce concern in the market with this loss
by announcing that it was significantly reducing its leverage ratio and that
it had reduced assets on its balance sheet by $60 billion. However, it failed
to disclose that this was accomplished through an accounting manipulation
that was referred to internally as Repo 105. That transaction bent accounting
rules to treat the repo of those assets as a sale rather than as a financing. Such
transactions are not inherently improper but a bankruptcy examiner found that
Repo 105 was used to allow Lehman Brothers to reduce its leverage ratio and
to avoid writing down those assets.
Repo 105 resembled some of the Enron-era off-balance transactions that
caused controversy. Lehman claimed that what would otherwise have been a
simple repo transaction was converted into a “true sale” that took the assets
off its balance sheet because the securities on repurchase need not be the same

ones as originally sold. No U.S. law firm would provide an opinion that this
was in fact a true sale, but Lehman found a London law firm that expressed
such an opinion under English law. Bank of America engaged in similar
conduct at quarter ends between 2007 and 2009 in order to reduce the size of
its balance sheet in its quarterly reports and to meet internal financial targets.
Citigroup also admitted to misclassifying $9.2 billion in repo agreements in
order to hide debt and reduce balance sheet amounts.
Lehman Brothers claimed that it had a large liquidity pool to support its
operations but did not disclose that many of the assets in the pool were illiquid.
Lehman was able to engage in these manipulations despite the fact that there
were teams of government regulators and investigators from the Fed and SEC
on its premises who were closely following its operations and risk exposure
after the failure of Bear Stearns.
The price of Lehman’s stock continued to plunge. In order to quell rumors
and speculation, Fuld said that Lehman Brothers would continue to operate
as an independent investment bank and had no plans to merge with a large
bank. That statement bought no relief. The price of Lehman Brothers shares
dropped sharply on July 1, 2008, amid speculation that the firm was in seri-
ous trouble. More concern was raised after Lehman announced in August
the closure of its remaining subprime mortgage operations and the layoff of
1,200 employees. Another 1,300 were laid off after Lehman shut down its
wholesale mortgage operation. Lehman Brothers had some 25,000 employees
before its failure.
The crisis peaked after Lehman Brothers reported that it expected a third-
quarter loss. Three more senior executives were dismissed on September 8,
2008, in a desperate attempt to manage its way out of a declining situation.
Lehman Brothers was also under attack from its trading counterparties. On
September 9, 2008, JPMorgan Chase demanded $5 billion in additional col-
lateral as support for Lehman’s credit line, but Lehman could raise only $3
billion immediately. Lehman then “pre-announced” the next day that it would
report a loss of $3.9 billion in the third quarter, bringing total losses over the
preceding six months to $6.7 billion. The bottom then dropped out from under
Lehman’s stock, and credit agencies put Lehman Brothers under a credit watch
and threatened to downgrade the firm if it did not raise more capital over the
following weekend. Such a downgrade would cause further liquidity strains
because it would cause more collateral to be demanded by counterparties.
Lehman attracted some $8 billion in collateral to support its credit line at
JPMorgan on September 12, but by this point Lehman had exhausted its col-
lateral pool, and other firms demanded payments. On September 10, 2008,
Henry Paulson, treasury secretary and former Goldman Sachs head, privately
advised Ben Bernanke, chairman of the Federal Reserve (the Fed), that he
would not support a bailout of Lehman Brothers. The Fed then tried to gather
support for a rescue from other investment banks. This was a high-stress
time, but Goldman Sachs CEO Lloyd Blankfein kept things in perspective.

On the way to a meeting to discuss a possible rescue of Lehman Brothers,

as it was about to fail, an aide complained of the stress from all the market
turmoil. Blankfein told him to stop complaining; after all, “You’re getting
out of a Mercedes to go to the New York Federal Reserve, you’re not getting
out of a Higgins boat on Omaha Beach.”3 Goldman did not participate in a
Lehman rescue.
A deal was struck in which Barclays would take over Lehman Brothers.
However, Barclays needed shareholder approval for such an acquisition, which
could not be obtained quickly. Therefore, a guarantee from either the U.S. or
the UK government was needed to cover Lehman Brothers trading balances
until such a vote could be conducted. No such government guarantee was
forthcoming. Alistair Darling, chancellor of the exchequer, told Paulson, “We
are not going to import your cancer.”4 The Financial Services Authority (FSA)
in London refused to waive the rule requiring a shareholder vote. Timothy
Geithner, at the time the president of the Federal Reserve Bank of New York,
sought to provide the guarantee to Barclays but was told by Fed lawyers that
there was no authority for such action on the part of his bank.
Lehman failed after Paulson refused to use government funds to back a
rescue of that firm. According to some reports, Fuld had purportedly angered
Paulson at a meeting at which they had discussed Lehman’s mounting prob-
lems, reportedly telling the treasury secretary: “I’ve been in my seat a lot
longer than you were ever in yours at Goldman. Don’t tell me how to run my
company. I’ll play ball, but at my speed.”5 Fuld refused to take the aggressive
steps that Paulson thought were needed for Lehman to remain viable. Among
other things, Fuld refused to deleverage the firm. He sought to sell the firm to
the Korea Development Bank in a deal that would have involved the purchase
of 49 percent of Lehman at $23 per share. As Lehman’s shares plunged in
price, that purchase price was reduced to $18 per share, then $6.40, and finally
the deal failed. Negotiations with Citic Securities, a Chinese firm, for a sale
of 50 percent of Lehman also fell through.
Paulson denied personal animosity toward Fuld, claiming that there was
simply no political will in Washington for a government bailout of Lehman.
Paulson was still smarting from widespread criticism of the use of government
funds to bail out Bear Stearns. He was quoted as saying: “I’m being called Mr.
Bailout. I can’t do it again.”6 An emergency meeting was held on September
12, 2008, with Paulson, Geithner, and the CEOs of Bank of America, Barclays,
UBS, JPMorgan Chase, Goldman Sachs, and Citigroup, all of whom refused
to arrange a private rescue of Lehman Brothers in the absence of government
guarantees.
Lehman Brothers reported on September 12 that it had a liquidity pool of
$41 billion, but the pool contained only $2 billion in securities that could be
monetized. Fuld desperately tried to persuade Bank of America to take over
Lehman Brothers over the weekend of September 13, 2008. However, the
bank’s CEO, Kenneth D. Lewis, refused to return Fuld’s phone calls because

he was engaged in discussions about taking over Merrill Lynch. Lehman tried
to arrange a capital infusion from other sources but was unsuccessful. In a state
of chaos, Lehman Brothers failed in the early morning hours of September
15, 2008. A later report by a consultant to the bankruptcy court concluded that
some $75 billion in value at Lehman Brothers was destroyed by the chaotic
nature of its bankruptcy filing. This was because some complex transactions
on its books could not be unwound rapidly in an orderly manner. The report
charged that this was an unconscionable waste of value. It was, in any event,
an expensive bankruptcy. Lehman’s bankruptcy law firm, Weil Gotshal, sought
$55 million for one quarter’s work in April 2009, and PriceWaterhouseCooper’s
accounting work on aspects of Lehman’s bankruptcy in Europe alone totaled
$252 million through October 2009.
Lehman Brothers issued many statements before its failure asserting that it
was in good capital shape with plenty of liquidity and blamed short-sellers for
its plunging stock price. However, it appeared that the firm had concluded that
it needed at least $3 billion in additional capital even as it assured financial
analysts that no more capital was needed. Newspaper reports also suggested
that Lehman’s real estate portfolio was overvalued by more than $10 billion.
Just before Lehman Brothers failed, creditors examining its books concluded
that its total assets were overvalued by as much as $30 billion. Creditors were
expected to receive only ten cents on the dollar from the bankruptcy. Compli-
cating that recovery was the fact that Lehman Brothers had moved some $8
billion from its operations in London to New York just before its bankruptcy.
Administrators for the Lehman Brothers estate in London demanded the return
of those sums.
The firm had tried to negotiate other relief from the Fed before its collapse.
It wanted broader access to credit resources at the Fed and to convert itself into
a national bank. The Fed rejected that proposal, but later allowed Goldman
Sachs and Morgan Stanley to attain national bank status after Lehman failed.
The Fed did lend $138 billion to Lehman’s broker-dealer unit on September
15, 2008, after the company was already bankrupt. The loan was made to as-
sure that the broker-dealer had adequate liquidity, and because it was insured
by the Securities Investor Protection Corporation (SIPC), the government had
an interest in protecting its operations. Lehman Brothers had packaged some
of its illiquid credit instrument investments into pools on which it issued debt
certificates that were secured by those investments. The certificates received
an investment-grade rating, and Lehman Brothers used those certificates as
security for loans from the Fed before failing. Barclays Bank bought that Leh-
man unit and agreed to take over the Fed loans to Lehman, so the government
suffered no losses.
Nomura Holdings, Japan’s largest brokerage firm, bought Lehman Brothers’
international operations in Asia and Europe. It paid $225 million for the Asian
operations and experienced significant losses in integrating those operations.
Barclays agreed to buy Lehman Brothers’ fixed income market operations

and its buildings for the bargain price of $1.75 billion. Barclays took none of
the Lehman debt or troubled assets. Lehman Brothers executives claimed that
the Lehman assets sold to Barclays had been substantially undervalued, and
a judge allowed an investigation of that charge. Neuberger Investment Man-
agement, the investment management arm of Lehman Brothers, was valued
at $10 billion in the summer of 2008. After Lehman’s bankruptcy, Neuberger
was offered to two private equity groups, Bain Capital Partners and Hellman
& Friedman, for $2.15 billion. However, after the value of Neuberger’s as-
sets under management fell from $230 billion at the end of August to $160
billion at the end of November 2008, the private equity firms sought to have
the price reduced. Instead, it was auctioned off to Neuberger managers who
purchased 51 percent of its stock, while the rest remained with the Lehman
Brothers bankruptcy estate.
Lehman Brothers became a target of Congress after its failure. The firm
paid $23 million to three departing executives just before it collapsed. Its
CEO, Richard Fuld, was called before a congressional committee on October
6 and was criticized for the hundreds of millions of dollars he had made at the
firm over his forty-year career. Fuld denied making any misrepresentations
concerning the company’s financial situation before its collapse.
The Lehman Brothers bankruptcy examiner later found that the firm failed
because it lost the confidence of its lenders and counterparties, resulting in
insufficient liquidity to meet its obligations. Lehman’s liquidity problem was
found to be the result of concentrations of illiquid assets with deteriorating
values such as residential and commercial real estate. Confidence was further
eroded when attempts to form strategic partnerships to bolster its stability
had failed. The second- and third-quarter losses further undermined Lehman
Brothers’ credibility in the market. The failure of this business model was found
by the examiner to be a matter of business judgment that was not actionable.
However, the examiner charged that the failure to disclose the effects of those
business judgments, and the accounting manipulation effected by Repo 105,
gave rise to colorable, or valid, litigation claims against Fuld and Lehman CFOs
Christopher O’Meara, Erin M. Callan, and Ian T. Lowitt. The examiner also
asserted that there were colorable claims against Lehman’s accounting firm,
Ernst & Young, for failure to challenge improper or inadequate disclosures in
Lehman’s financial statements. These findings came at a cost. The Lehman
Brothers bankruptcy fees were in excess of $730 million by May 2010.
After Lehman declared bankruptcy, the Federal Home Loan Mortgage
Corporation, known as Freddie Mac, was left holding $1.2 billion in Lehman
commercial paper. The triple-A-rated swap subsidiaries of Lehman Brothers,
which were supposed to have had more than enough capital to cover obliga-
tions, but, in what appeared to be an asset grab, were placed into bankruptcy
anyway. Credit-default swaps (CDSs) were tested by the Lehman Brothers
bankruptcy with better results. An auction was held to determine the value
of Lehman’s bonds in bankruptcy, and they were valued at about $.08 on the

dollar, which meant that the paying party on these credit default obligations
would have to pay $.92 on the dollar and within two weeks. Lehman’s total
swap book had an open notional total of over $400 billion. However, Lehman
Brothers’ net open positions in the CDS market were only a few billion dollars,
and those claims were resolved amiably and on time.
Fallout from the Lehman Brothers collapse continued. Several large
brokerage firms, including Lehman Brothers, had created an entity called
the Customer Asset Protection Company (CAP), whose role was to provide
account insurance above the $500,000 provided by the SIPC in the event of
a broker-dealer’s insolvency. However, that insurer had only about $150 mil-
lion in reserves to cover the Lehman claims, which were expected to exceed
$10 billion.
The failure of Lehman Brothers set off another liquidity crisis around the
world. The Dow plunged by 500 points on September 15, 2008, falling to
10917.51 and making this the worst day on Wall Street since the decline after
the September 11 attacks. An estimated $700 billion in stock value evaporated
that day in 2008. The Securities and Exchange Commission (SEC) applied a
complete but temporary ban on short selling to 799 financial stocks on Sep-
tember 19. However, as OneChicago general counsel Don L. Horwitz advised
short-sellers, they could avoid such restrictions by selling single stock futures
on that exchange, and there were other ways to flout the ban as well.
Reserve Primary Fund
On September 16, the day after Lehman Brothers’ failure, the Reserve Primary
Fund “broke the buck,” which meant that investors would receive less than
$1 for each $1 invested, setting off market turmoil and panic. The Reserve
Primary Fund held commercial paper issued by Lehman Brothers, which was
marked down to zero by the fund’s managers after Lehman’s bankruptcy. The
fund was a member of the Reserve complex of money market funds created by
the two inventors of the money market fund concept, Bruce Bent and Henry
B.R. Brown, both of whom had been employees of the financial services firm
TIAA-CREF. Bent was still chairman of the Reserve fund complex when Leh-
man Brothers declared bankruptcy. Brown, who was also an early pioneer in
Internet banking, retired from the Reserve funds in the 1980s. He died only
one month before the September crisis at the Reserve Primary Fund.
Bent came under fire for investing in the Lehman Brothers commercial paper.
He criticized other money market funds in the week preceding the Lehman
Brothers bankruptcy for not knowing the full risks of their investments and
had preached against commercial paper investments by money market funds
for years. He had been quoted as saying, “we don’t drink, smoke or buy com-
mercial paper.”7 However, as yields lagged at the fund, it started investing in
commercial paper, which allowed it to report the highest yield in the industry
by September 2008. Its investors had a return on investment of 4.04 percent

versus the industry average of only 2.75 percent. That yield allowed the fund
to attract more investors, which increased the fees to its principals, including
Bent.
The Reserve Primary Fund imposed a seven-day moratorium on redemp-
tions after the announcement that the fund had broken the buck, but not before
investors demanded $40 billion in withdrawals. Some of those withdrawal
demands began before the fund’s public disclosure of its loss, occasioning
lawsuits claiming that some larger investors had been tipped off in advance
on the loss. Only about $10 billion was paid out on these demands before the
Reserve Fund was frozen. On September 30, 2008, the fund announced the
return of $20 billion to investors, but that was only about 30 to 40 percent of
their investment. The fund sent investors checks for half the amount in their
accounts at the end of October and promised that more would be distributed
later. It appeared that the fund was illiquid, preventing further distributions,
which was a strange position for a money market fund that was supposed to
be nearly completely liquid.
The fund held $62 billion at the time of its collapse, of which only $785
million was invested in Lehman notes. The fund’s biggest loss turned out to
be a $3.5 billion reserve set up to cover the costs of regulatory actions and
twenty-seven investor lawsuits. This would have reduced investors’ final
recovery to 97 cents on the dollar. The fund was then hit with a number of
lawsuits, which it asked to be stayed or dismissed because it would simply
use customer funds to fight those lawsuits.
Questions were raised about an error that delayed reporting that the fund
had broken the buck five hours earlier than first reported. Although that ap-
peared to be a quibble, Massachusetts regulators charged that the fund had
issued false information concerning its status in order to stop a run on its assets.
Bruce Bent and his son, Bruce Bent II, were charged by the SEC with failing
to disclose the extent of its losses in a two-day period after Lehman Brothers
declared bankruptcy. The SEC also wanted the funds reserved for litigation
to be returned to investors immediately.
Six weeks after that money market fund encountered problems, investors
in the fund still had not received all their money. To alleviate their concern,
the Treasury Department announced on November 20, 2008, that it would act
as a buyer of last resort for assets of the fund. In the end, an asset allocation
plan was approved in November 2009 that would return $0.99 on the dollar
and possibly more. Distributions were still being made in July 2010.
In the meantime, the events at the Reserve Primary Fund triggered a panic in
other money market funds. Time magazine had warned as early as 1959 that a
broad market decline could cause mutual fund investors to redeem their shares
and cause the collapse of the market as mutual funds liquidated their invest-
ments. Money market funds were not yet invented, but that warning applied
to them as well. Another prediction of a bank run on mutual funds was made
in 1960, and Henry Kaufman made a similar prediction in 1994.8 Kaufman,

while working at Salomon Brothers in the 1970s and 1980s, became famous
as “Dr. Doom” for his forecasts that interest rates would rise and bond prices
would fall. Ironically, Kaufman was a director of Lehman Brothers Holdings
and a member of its finance and risk committee. Although he lost money in
the Bernard Madoff Ponzi scheme, he was reported to otherwise have had a
good year in 2008 by shorting the S&P 500.
Kaufman wanted money market funds to be regulated like banks because
they had become a substitute for bank deposits and argued that they should be
regulated in order to prevent deposit runs. He proposed that investors in money
market funds be required to give sixty or ninety days’ notice of withdrawal,
a requirement used for certificates of deposits and time deposits at banks.
However, the Investment Company Institute and the New York Fed published
studies demonstrating that mutual fund shareholders had never panicked and
redeemed en masse. As a result, the Kaufman proposal got nowhere, but he
was not wrong in expressing concern over the possibility of such an event,9
because that is what happened after the Reserve Primary Fund failed.
Other money market funds had problems because they invested in asset-
backed commercial paper (ABCP) and other commercial paper, but those
markets were frozen. Investors responded to those problems by exiting the
money market funds en masse, as shown by the net outflow of $200 billion
in the two-week period following the Reserve Primary Fund’s problems. Of
that amount, $125.2 billion was withdrawn during the week of September 17,
2008. Investors began to make panicked withdrawals in fear that other money
market funds would also break the buck. In comparison, there was a net inflow
of $28.4 billion in the previous month. This was a very worrisome situation.
The panic in the money market funds spread like wildfire until the Treasury
Department stepped in and announced on September 19 that it would provide
$50 billion to temporarily guarantee the money market funds against loss. That
stabilized the situation. The guarantee was to expire on December 18, 2008,
but was thereafter extended into 2009. Money market funds that wanted to
participate in this program were charged a fee based on the net asset value as
of September 19, 2008. The program covered more than $3 trillion of partici-
pating money market fund assets.
The funds for this guarantee came from the Treasury’s Exchange Stabiliza-
tion Fund, which was created by the Gold Reserve Act of 1934; it was previ-
ously used to stabilize currency rates and to bail out Mexico when it faced a
financial crisis in 1995. The money market mutual fund guarantee announced
by the Treasury Department caused concerns that funds might be withdrawn
from certificates of deposit, which were able to pay lower interest rates than
the money market funds because of the Federal Deposit Insurance Corporation
(FDIC) guarantee. Higher rates on certificate of deposits would only worsen
bank problems. The SEC responded to money market liquidity problems with
proposals in 2009 that would require money market funds to remain more
liquid. However, the SEC already had a rule on its books (Rule 2a-7) that had

placed maturity and quality restrictions on money market funds that were
intended to prevent the problems encountered by the Reserve Primary Fund.
Once again, SEC regulation proved ineffective.
The breaking of the buck by the Reserve Primary Fund also set off wide-
spread panic in money market funds for professional investors, which began
massive withdrawals of their funds. Putnam Investments, which had serviced
professional investors and held $12.3 billion in assets, closed its Putnam Prime
Money Market Fund on September 18, 2008. Another fund used by profes-
sional investors, the BNY Institutional Cash Reserves, which was sponsored
by Bank of New York Mellon, broke the buck on September 18, 2008.
Lehman Brothers’ failure also caused problems in its own “stable-value”
fund, which was managed by Invesco. Such funds seek to maintain principal
at par and to provide a stable return by investing in high-grade corporate
bonds and other longer-term fixed income instruments. The Lehman Brothers
stable-value fund, like other such funds, was insured against loss by third-party
financial institutions, should the fund fall below par. However, the Lehman
Brothers insurance program for the fund terminated the insurance in the event
of bankruptcy. As a result of that termination and a drop in bond prices, inves-
tors faced a small loss at year-end 2008.
On October 21, 2008, the Treasury Department announced the creation of a
Money Market Investor Funding Facility that would allow the New York Fed
to provide up to $540 billion in senior secured funding to five special-purpose
vehicles managed by JPMorgan Chase. This program sought to protect prime
money market funds, which had experienced a $500 billion decline in their
holdings since the beginning of September, and those funds suffered liquidity
problems. The special-purpose vehicles were to be used to buy money market
instruments such as certificates of deposits, bank notes, and commercial paper
with a maturity of ninety days or less. These special-purpose entities were
authorized to sell ABCP as well as to borrow money from the Fed.
The AIG Debacle
On September 16, 2008, the day after it allowed Lehman Brothers to fail, the
federal government stepped in to rescue American International Group (AIG),
one of the nation’s largest insurance companies. The demise of AIG had its
roots in the Enron-era scandals involving the then-New York attorney general,
Eliot Spitzer. Spitzer first went after Marsh & McLennan, the world’s largest
insurance broker, charging that it had defrauded its clients by accepting fees
from insurance companies in exchange for steering its clients to those insurance
companies. Marsh & McLennan paid $850 million in “restitution” to settle
Spitzer’s claims, and it and other large insurance brokers agreed to give up the
“contingent commissions” that were the target of Spitzer’s attacks, costing them
more than $1 billion in revenue. Those commissions were paid to brokers by
insurers based on the amount of coverage placed with the brokers’ clients.

Spitzer indicted sixteen Marsh & McLennan executives, several of whom

pleaded guilty to criminal charges. Spitzer used those guilty pleas to respond
to the U.S. Chamber of Commerce, which had been critical of his attack on
these common industry practices. The chamber’s president, Tom Donohue,
charged that Spitzer was acting as “the investigator, the prosecutor, the judge,
jury and executioner.” William Gilman and Edward J. McNenney, two execu-
tives from Marsh, Inc., which was owned by Marsh and McLennan, refused
to enter a plea, and in February 2008 they were found guilty of violating the
New York Donnelly Act, an antitrust statute, but acquitted of fraud and other
charges. They were sentenced to sixteen weekends in jail, placed on probation
for five years, and required to perform community service. However, a state
court judge set aside their convictions in July 2010 because of prosecutorial
misconduct in withholding hundreds of thousands of pages of documents from
the defense lawyers, some of which contained exculpatory evidence. The at-
torney general’s office vowed to appeal that ruling. After a bench trial lasting
eleven months, three other Marsh & McLennan executives were acquitted of
all charges in October 2009. Charges against two other Marsh & McLennan
executives were then dropped by Andrew Cuomo, Spitzer’s successor as at-
torney general.
At Spitzer’s direction, Marsh & McLennan issued a public apology for its
conduct and forced its CEO, Jeffrey W. Greenberg (the son of Hank Greenberg,
the CEO of AIG), to resign. Several other officers were also forced out, and the
board of directors was reorganized, again at Spitzer’s demand. Spitzer required
the entire board to be composed of outside directors who knew little or noth-
ing about the company. Marsh & McLennan was also required to separate the
roles of chairman and CEO, a popular reformist measure that had played such
a high-profile role in the SEC’s reform efforts after the Enron-era scandals.
The corporate governance changes required by Spitzer at Marsh & McLen-
nan did nothing to improve its profitability. Michael G. Cherkasky, Greenberg’s
successor as CEO at Marsh & McLennan, proved to be unable to successfully
run the company. The profitability of the company suffered under Cherkasky’s
three-year regime. He was dismissed after the company’s earnings fell by 62
percent in the fourth quarter of 2007, replaced by Brian Duperreault, an execu-
tive who had spent several years at AIG. The new management at Marsh &
McLennan quickly announced plans to restructure the company.
After Spitzer was forced to resign as governor of New York, Marsh &
McLennan approached the new attorney general, Andrew Cuomo, and pe-
titioned him for permission to drop the prohibition on charging contingent
commissions. Cuomo appeared to be receptive to that request, agreeing to hold
hearings on that proposal with the New York State insurance superintendant,
Eric Dinallo. Cuomo stated that the hearings would seek to determine whether
such commissions posed an irreconcilable conflict of interest, as Spitzer had
claimed. The New York Insurance Department later agreed to allow Marsh &
McLennan and others to charge contingent commissions.

In the meantime, Spitzer turned his attentions to AIG and forced Hank
Greenberg, the firm’s founder, to resign in 2005 over charges of improper
accounting. Not satisfied to let the matter rest, Spitzer startled the legal com-
munity when he charged in a television interview that Greenberg had commit-
ted fraud and that the only issue was whether Greenberg should be sanctioned
by civil or criminal charges. The Wall Street Journal was highly critical of
Spitzer’s use of television instead of the legal system to indict Greenberg. The
New York Times then charged in a headline, referring to Hank Greenberg: “An
Industry Bully Gets Its Comeuppance.” John C. Whitehead, former chairman of
Goldman Sachs, defended Greenberg—voted CEO of the year in 2003—in an
op-ed in the Wall Street Journal, stating that Greenberg was “one of America’s
best CEOs and most generous philanthropists.”
Whitehead also criticized Spitzer for having claimed that Greenberg had
committed fraud before any charges were proven or even filed. Spitzer re-
sponded with an attack on Whitehead. According to Whitehead, who published
this exchange in a letter to the editors of the Wall Street Journal, Spitzer called
him and said:
Mr. Whitehead, it’s now a war between us and you have fired the first shot. I will be
coming after you. You will pay the price. This is only the beginning and you will pay
dearly for what you have done. You will wish you had never written that letter.10
Whitehead remarked that this conversation was “a little scary.” For his part,
Spitzer claimed that Whitehead was lying about the conversation, a claim
that was not widely believed. In a separate incident, Spitzer threatened the
producer of a radio show with some unspecified retaliation after being chal-
lenged on the producer’s radio show. Spitzer also increased the scope of his
war against Greenberg by publicly claiming that Greenberg had defrauded a
charity some thirty-five years earlier, but never filed charges relating to this
allegation. Spitzer also backed off his threat to indict Greenberg for fraud.
Instead, he brought a civil suit against Greenberg for his activities as head of
AIG, though he subsequently dropped two of the six counts in that complaint.
That lawsuit was still unresolved years later.
AIG entered into a deferred-prosecution agreement with the Justice Depart-
ment and a settlement with the SEC in which it agreed to pay $136 million
for assisting PNC Financial Services Group and Brightpoint, in the manipula-
tion of their accounting statements. PricewaterhouseCoopers agreed to pay
$97 million to an Ohio State pension fund to settle claims over its audits of
AIG. AIG also agreed to the appointment of a corporate monitor tasked with
reviewing its accounts for improprieties. The corporate monitor appointed
was James Cole from the law firm of Bryan Cave, for which he and the firm
were paid $20 million.
Cole’s role was expanded after AIG was forced to apologize for its bid rig-
ging and accounting practices and agreed to pay $1.64 billion to settle charges
brought by Spitzer and the SEC over those activities. AIG also restated its

earnings over several years by a total of $3.9 billion. Under the AIG settlement
agreement with the regulators, Cole was to review AIG’s financial controls
and compliance programs. Cole participated in board and committee meetings,
but he was blithely unaware of the risks that AIG was incurring in its financial
products division that led to its failure.
Other firms were caught up in the Spitzer-era insurance scandals. Travel-
ers Companies agreed to pay $6 million in 2007 to settle charges brought
by several states. Zurich American Insurance agreed to pay $171.7 million
to settle claims by nine states that it engaged in improper bid-rigging prac-
tices in its commercial insurance contracts. The federal government brought
criminal charges against four executives at the giant reinsurance company
General Re—Ronald E. Ferguson, CEO for Gen Re and previously an of-
ficial at the Federal Reserve; Elizabeth Monrad, the company’s CFO; Robert
Graham, a General Re senior vice president and assistant general counsel;
Christopher P. Garand, senior vice president responsible for Gen Re’s finite
reinsurance operations—and against one executive at AIG, Christian Milton,
a vice president of reinsurance. The indictment charged that the defendants
created a fraudulent scheme to inflate AIG’s loss reserves through the use of
fictitious transactions between subsidiaries of AIG and Gen Re. That boost
was needed because financial analysts were concerned over a $60 million
decrease in AIG’s loss reserves in the third quarter of 2000. The defendants
were alleged to have manipulated AIG’s loss reserves in 2000 and 2001 by
some $500 million through “finite” insurance, a complex product that is sup-
posed to insure for the time value of money but was used here to disguise the
amount of reserves set aside for potential losses.
This was a high-profile case, since Gen Re was controlled by Warren Buf-
fett’s Berkshire Hathaway and received a $5 million fee for arranging this
transaction. The government charged that the participants had maintained a
secret understanding that no underwriting risk would actually be transferred
to General Re. The trial of the General Re executives included numerous
tape-recorded phone conversations that those executives had not realized were
being taped. In one such conversation, an executive asked in wonderment,
in reference to AIG, “how much cooking goes on in there?” The defendants
claimed that Buffett had been advised of the arrangement and did not object
to the transaction. However, Buffett never appeared at trial, and the defen-
dants were unable to prove that claim. All four were convicted by a jury on
February 25, 2008.
Two other Gen Re executives, John Houldsworth and Richard Napier, struck
plea bargains with prosecutors and agreed to testify for the government at the
trial in exchange for two years’ probation. Ferguson was sentenced to four
years in prison, Monrad got eighteen months, and Graham and Garand were
sentenced to a year and a day. AIG agreed to pay $72 million to the Ohio at-
torney general on behalf of three state pension funds to settle claims over its
role in the transaction with General Re.

General Re agreed in 2010 to a deferred prosecution agreement to end its

problems with the Justice Department with a mea culpa and a payment of $92
million. The chief financial officer of Berkshire Hathaway was required by
this agreement to attend General Re audit committee meetings, and General
Re was required to appoint an independent director. Corporate compliance
programs were also required.
Federal prosecutors also demanded that Berkshire Hathaway fire the General
Re CEO, Joseph P. Brandon, even though he was not charged with any crime
and had cooperated fully with prosecutors without immunity. In the face of that
pressure, Brandon resigned as CEO and chairman of General Re on April 14,
2008. Many thought that Brandon was a leading candidate to succeed Buffett,
in the event that he decided to step down at Berkshire Hathaway.
Greenberg, who was a veteran of the Normandy invasion during World
War II and of the Korean War, headed AIG for forty years and had built it into
one of the world’s largest insurance companies, a $100 billion enterprise that
employed thousands. He fought back after his ouster from AIG. Greenberg
controlled Starr International, which owned 10 percent of AIG and set the
compensation for executives at AIG. In this capacity, he dismissed the AIG
directors from the Starr board, which resulted in more turmoil at AIG. He also
accumulated shares of AIG, stating that he was looking at “strategic alterna-
tives” for the company, which suggested to the market that he was seeking to
regain control of AIG. However, Greenberg was forced to back off that threat
after being told by the New York Insurance Department that such an acquisi-
tion would have to be approved by Dinallo, the superintendent of insurance.
That approval was not likely to be forthcoming because Dinallo had been a
prosecutor in Spitzer’s office and had been appointed as superintendent when
Spitzer became governor. Nevertheless, Greenburg built up a group of insur-
ance companies through Starr International and recruited AIG employees who
were susceptible to a change after the government imposed pay curbs at AIG
in 2009 after its bailout.
Frank Zarb, a former NASDAQ executive, became the new chairman of
AIG after Greenberg’s ouster. Zarb recruited former SEC chairman Arthur
Levitt, who had converted himself into a corporate gadfly after leaving the
SEC, to join the AIG board as an adviser. Martin J. Sullivan became the new
CEO at AIG. Shortly after Greenberg was fired, AIG restated its financial
positions and blamed Greenberg for those problems. However, Greenberg’s
attorneys countercharged that there were no reasons for the restatements and
that the company’s new management was simply trying to manipulate the
books so that they would look better in future quarters. In fact, the company
did record profits in 2006, and several of the earlier changes were subse-
quently reversed.
In August 2009 Greenberg settled a suit in which the SEC charged that he
had been a “controlling person” with respect to a portion of AIG’s accounting
misstatements. Essentially, the SEC claimed that he had concealed an under-

writing loss by converting it to an investment loss after having boasted that

AIG never had an underwriting loss, and he did not want to retract that claim.
Greenberg was not charged with fraud in the SEC suit, and he agreed to pay
only $15 million in settlement, which was less than what his attorney fees
would have been if the case had gone to trial. He was not barred from serving
as an officer of a public company, as is typical in similar SEC suits.
AIG and Greenberg sued and countersued each other over these and other
issues. Indeed, the AIG board and Sullivan devoted much of their time to
dealing with the Greenberg challenges to their control and seemed to have
lost focus on their business. Some of their tactics appeared to be in bad faith,
if not frivolous. For example, Greenberg sought documents from the com-
pany’s lawyers that he claimed would exonerate him from the charges that
he had improperly approved some finite insurance. Certainly, preferring not
to produce documents that might exonerate Greenberg, the company tried to
withhold them at all costs. AIG lost on the issue in the appellate division of
the New York courts, but it continued to fight by appealing to the New York
Court of Appeals.
Greenberg and three other former AIG executives settled a class-action
lawsuit for $115 million related to their activities at Starr. However, most of
the funds for the settlement were paid from insurance policies. Greenberg’s
attorney stated that Greenberg was paying nothing out of his own pocket. AIG
filed a lawsuit against Greenberg and other former AIG executives in March
2008, in which it was claimed that in 2005 the defendants had misappropriated
a large block of AIG shares, held by Starr, worth $20 billion. The case went to
trial in June 2009, and an advisory jury ruled in Greenberg’s favor. The federal
judge hearing the case thereafter affirmed the jury’s decision. Greenberg also
reached an oral agreement with Cuomo to settle the charges against him, but
that agreement fell apart when AIG collapsed.
Sullivan and Greenberg sparred in the press over each other’s executive
abilities. Sullivan scored a few debating points but ultimately proved Green-
berg’s charge that he was not competent to run a complex enterprise such as
AIG. He was able to survive for a time on his image as a “white knight” who
had cleaned up AIG. Under his stewardship AIG was able to claim record
profits for 2006, but that was only a temporary gain, and Sullivan’s aura as a
hero quickly wore thin when the company encountered massive losses during
the subprime crisis.
In all events, AIG was in a downhill slide under his tenure. Some of it was
just bad luck, as AIG suffered from payouts due to hurricanes and an earth-
quake. However, the troubles that led to AIG’s demise were more directly
traceable to 2005, when the company vastly increased its CDSs, apparently as
a substitute for the business stopped by Spitzer. As Greenberg later charged in
testimony before Congress in 2009, AIG more than tripled its CDS business
because the new management had gotten greedy. However, much of that busi-
ness involved CDSs on super-senior CDO tranches. These were the payment

streams from the CDOs that were rated above investment grade, even triple-A,
by the rating agencies. Normally, such ratings meant an investment was a safe
one. For that reason, Sullivan had stated in December 2007 that the probability
of an economic loss from that exposure was near zero.
AIG entered into CDSs with a notional amount of $440 billion by 2008.
Many of these swaps required no collateral from AIG unless it had a credit
rating downgrade, which, of course, is what occurred. Others swaps were “pay-
as-you-go,” which meant that they were tied to the mark-to-market value of the
underlying obligations, which declined as the subprime crisis worsened. AIG’s
auditors, PricewaterhouseCoopers, later concluded that AIG had a “material
weakness” in its accounting controls concerning the way in which it valued
its exposure to mortgage-related investments.
AIG had to provide $2.5 billion in funding in January 2008 in order to rescue
one of its structured investment vehicles (SIVs), Nightingale Finance. AIG’s
share price also dropped sharply after it reported a large fourth-quarter 2007
loss that was accompanied by a $5.29 billion writedown of its mortgage-related
business, including that of its CDS business by $4.88 billion. Sullivan blamed
mark-to-market accounting requirements for the loss. He complained that AIG
was required to mark down its inventories even though it had no intention of
selling them. AIG reported another loss in the first quarter of 2008, this time
$7.81 billion, the largest quarterly loss in the company’s history. Losses were
largely attributable to CDS positions, which required a $9.1 billion writedown.
Sullivan claimed the fair-value accounting requirement was responsible for
these losses.
The CDS market was tested after the Lehman Brothers bankruptcy. All
CDS claims for Lehman debt were resolved amiably and on time. However,
there were other earlier instances in the CDS market of quarrels over whether
trigger events had actually occurred that would require the credit protec-
tion seller to pay up. To resolve such issues, the International Swaps and
Derivatives Association (ISDA) developed a protocol requiring participants
to submit their dispute to a determination committee of investors and swap
dealers. However, AIG, which suffered losses of $100 billion over a fifteen-
month period, largely from CDSs, refused to sign the protocol, preferring to
negotiate its wind-downs bilaterally with each counterparty. This immensely
complicated its positions.
AIG announced an attempt to raise $12.5 billion in new capital, but later
raised that figure to $20 billion. Greenberg responded with a fiery letter to the
AIG board demanding that its annual meeting be postponed. He charged that
AIG was in crisis and asserted that the company was falling apart. The board
rejected that demand, and the annual meeting of AIG was held on schedule. The
company’s board members and executives provided no real hope for investors
at that meeting, but they did state that they shared the investors’ frustration
and concern. They were also “disappointed” and “unhappy.”
This did not assuage shareholder concerns, and a group of large investors

challenged the AIG board on Sullivan’s lack of executive abilities and decried
the staggering breakdown of risk controls at the company. They also sought
replacement of at least some of the members of the board of directors at AIG.
Furthering Sullivan’s misery was the disclosure in June 2008 of an SEC and
Justice Department investigation into whether AIG had inflated the value of
its CDSs, valued at about $60 billion on the company’s books.
This all proved too much for the AIG board, and Sullivan was fired on June
15, 2008, to be replaced with Robert Willumstad, a former Citigroup execu-
tive. Willumstad announced that he would sue for peace with Greenberg and
proposed a meeting. Peace was needed because AIG posted another huge
loss totaling $5.4 billion in the second quarter of 2008. The second-quarter
loss was the result of a $9.1 billion writedown. AIG’s share price declined 18
percent after that announcement; it had fallen from $72 in February 2005 to
$39.57 on May 15, 2008.
An editorial in the Wall Street Journal on May 16, 2008, charged that
Spitzer’s campaign against AIG had crippled the company and deprived it
of the needed management of Greenberg.11 Richard Beattie, an attorney for
AIG, responded with a letter to the editor claiming that Greenberg had been
responsible for the positions that caused the losses on the books of the com-
pany. Greenberg’s lawyer, David Boies, retaliated with a letter stating that the
company’s own documents showed that the positions that caused the losses
were entered into after Greenberg left. Beattie denied claims that Spitzer had
demanded Greenberg’s departure as a condition for not indicting the company.
Boies refuted that assertion as well.
Greenberg’s holdings in AIG were valued at $802 million in December
2007. After its collapse, that holding was worth only $23 million. AIG was
in extremis as the result of a liquidity crisis. Joseph J. Cassano, the head of
AIG’s credit derivative group, was blamed for its problems, but he was given
a $43 million severance package by the company, as well as $280 million
in earlier bonuses. AIG had entered the CDS market in a big way in 2005
through its division called AIG Financial Products (AIGFP), which had been
founded by a group of traders from Drexel Burnham Lambert, the failed junk
bond broker. AIGFP’s computer models predicted that this business would
generate free money because in 1998 AIGFP’s model determined that there
was a 99.85% chance that it would never have to pay out anything and that
only a depression would cause losses. Cassano assured investors in August
2007 that “it is hard for us, without being flippant, to even see a scenario
within any kind of realm of reason that would see us losing $1 in any of
those transactions.”12
Cassano later testified that he had taken no undue risks at AIGFP, and that
the real problem was the margin demands made by other investment banks,
particularly Goldman Sachs. He testified that, if the government had not taken
over AIG, he would have refused or at least tempered those demands. Instead,
the government met the calls in full. In the event, federal prosecutors could

find nothing to charge Cassano with and they closed the case, but New York
attorney general Cuomo continued his probe. This was a sea change for federal
prosecutors who announced they were turning their attention to easier-to-prove
civil cases for financial fraud.
AIG’s stock-lending business also caused some large losses because it had
invested billions of dollars generated by its lending operations in subprime
mortgage instruments. Conventionally, stock-lending operations invest avail-
able funds in Treasury or other short-term, low-risk instruments. The purchase
of the riskier subprime instruments was part of an AIG program called “10
cubed,” which had as its goal to produce $1 billion in profits. That investment
had to be written down drastically.
Counterparties to AIG CDSs began to demand massive amounts of collateral
as the value of the swaps declined. This resulted in a classic run on the bank.
Many of these collateral calls came from large U.S. and foreign investment
banks. Goldman Sachs, one of AIG’s largest trading partners, had begun
marking down the value of super-senior subprime CDOs on its pay-as-you-go
swaps with AIG in 2007 but could not reach an agreement with AIG on their
value. It was able to obtain $7.5 billion in collateral from AIG and hedged the
remaining $2.5 billion of its AIG exposure.
AIG suffered $18.5 billion in losses over the preceding nine months from
writedowns that had not been predicted by its risk management models,
designed especially for AIG by Gary Gorton, a finance professor at the
Yale School of Management. AIG failed on September 15, 2008, after its
credit rating was downgraded by the rating agencies, causing its stock price
to fall by 43 percent. In a repeat of the Enron failure, that downgrade set
off triggers in its credit agreements with counterparties. At the time AIG
had outstanding credit protection worth a notional $441 billion, of which
$80 billion was subprime related. It could have been worse. AIG stopped
writing subprime protection in 2005 because of concerns over declining
credit quality.
After the rating cut, AIG was subjected to numerous collateral calls, total-
ing $13 billion. For example, it had to pay $800 million to Deutsche Bank as
credit support, $5.9 billion to Goldman Sachs, and a similar amount to Société
Générale. Because of the ratings downgrade, AIG also had to pay $727 mil-
lion in additional collateral on leases that it held for office space at Canary
Wharf in London.
Despite the hard-line approach taken against a government bailout of Lehman
Brothers, Treasury Secretary Paulson and Fed chairman Bernanke rescued AIG
on September 16, 2008. The turmoil set off after the Lehman Brothers demise
convinced them that the failure of another large financial services firms would
destroy the financial system. The possibility of AIG’s demise was particularly
troublesome because AIG had been a financial giant, with assets totaling some
$1 trillion. AIG’s U.S. life and health insurance business was the largest in the
country in terms of net premiums written and third largest in terms of total assets.

Its property and casualty insurance business was the second largest in terms of
premiums and third largest in total assets. AIG was also thought to be the largest
player in the CDS market. The firm did business in more than 130 countries and
had over 74 million customers and 116,000 employees worldwide.
Normally, the Fed consults with all the major players on Wall Street to find
out whether they will participate in the rescue of a failing financial institution.
In the case of AIG, Paulson apparently consulted only with Lloyd Blankfein,
his former colleague at Goldman Sachs, which had over $10 billion in expo-
sure to AIG. The government created an $85 billion credit line for AIG, then
increased the AIG bailout by $37.8 billion on October 8, 2008. Later this
rescue reached $207 billion in commitments, of which $144 billion had been
distributed by August 2009. In exchange, the government was given warrants
on 80 percent of AIG’s stock.
Willumstad was fired, and new management brought in. On October 3, 2008,
AIG drew down $61 billion on the line of credit from the Fed. The government
appointed three trustees to oversee the AIG board, who were given the author-
ity to vote the 80 percent government equity stake in AIG. This arrangement
displeased some members of Congress, who claimed that the trustees were
not independent and were actually controlled by the Treasury Department and
the Federal Reserve Bank of New York.
AIG also had to agree to some restrictions on its compensation program
for senior executives. Bonuses for senior officers for 2008 and 2009 could not
exceed the average bonuses paid in 2006 and 2007. In addition, bonuses for
the most senior executives could be no more than 3.5 times their base salary.
Further, no government funds could be used to pay annual bonuses or perfor-
mance awards for senior executives. Congress called the AIG executives to
testify and berated them for not firing a nonperforming consultant who was
paid $1 million per month.
Members of Congress were especially outraged about an AIG weeklong re-
treat at a California resort that cost $442,000, including $23,000 in spa charges,
that took place after the government created the credit line for the company.
Thereafter, many companies began to cancel their employee outings, causing a
severe blow to resorts across the country. The St. Regis Monarch Beach resort
where the AIG retreat had been held suffered a number of cancellations after
the AIG disclosures and was taken over by its mezzanine lender, Citigroup, in
July 2009. Northern Trust became the target of criticism over its sponsorship
of a golf tournament in California, where clients were lavishly entertained by,
among others, singer Sheryl Crow in a private performance. Goldman Sachs,
Merrill Lynch, and Morgan Stanley spent $750,000 to host clients at the U.S.
Open golf tournament in New York in the summer of 2009, but displayed no
corporate logos or advertising.
Sullivan was called before Congress after AIG’s failure to testify and reiter-
ated his claim that fair-value accounting had been to blame for the problems at
AIG. He noted that the CDSs written by AIG were on super-senior subprime

CDOs. He also noted that in 2005 AIG had started to pull back from other
subprime exposures because of credit concerns.
Cuomo announced on October 15, 2008, that he was investigating whether
executives at AIG had violated a New York law that prohibits fraudulent con-
veyances of corporate assets for less than fair value by reason of excessive
bonuses and lavish spending at the employee golf outing in California and on
an overseas hunting trip. Cuomo also investigated $19 million in severance
pay to Sullivan and a $10 million severance payment to Stephen J. Benziger,
the former AIG CFO. AIG then froze the severance payment due Sullivan,
pending this investigation. In the meantime, the New Orleans Employees’
Retirement System sued past and present AIG executives for its failure.
Cuomo’s targeting of the AIG bonuses appeared to be an effort to replicate
Spitzer’s unsuccessful attack on the pay packet of Richard Grasso at NYSE.
Senator Charles Grassley (R-IA) tried to stir controversy by asking all fifty state
attorneys general to investigate whether financial institutions were violating
state law through the misuse of taxpayer dollars to compensate executives,
such as those at AIG and elsewhere. In any event, things only got worse at
AIG. It was disclosed in December 2008 that the company faced a previously
undisclosed loss of an additional $10 billion from speculative transactions
sold by AIG Financial Products, where most of AIG’s already reported losses
had originated.
After it reported a $24.5 billion loss in the third quarter of 2008, AIG
announced that its CEO, Edward Liddy, would receive a salary of only $1.
Bonuses were also eliminated in 2008 for the top seven officers, and the top
fifty-seven officers of the company got no salary increases. This did not allow
Liddy to escape criticism in Congress. At one particularly acrimonious hearing
on May 13, 2009, Liddy was accused of being too secretive about AIG’s plans,
and he was pointedly reminded that the U.S. government owned 80 percent
of the company. He resigned after that experience, leaving AIG to search for
new management in the middle of the crisis.
As the condition of AIG continued to decline, the government agreed to
increase the amount to be injected into the firm. The terms of the rescue were
also eased so that AIG would not have to sell off distressed assets at fire-sale
prices. On December 24, 2008, the New York Fed bought $16 billion in CDOs
from AIG. These purchases were carried out through an entity called Maiden
Lane III, which was formed by AIG and the New York Fed in November as
a means of working out AIG’s investments in CDSs. AIG agreed to invest
$5 billion into that fund, and the New York Fed agreed to lend it as much as
$30 billion. Its purpose was to collect cash flows from CDSs that were then
to be used to pay off loans to AIG from the New York Fed and then to return
the $5 billion AIG investment. Thereafter, the parties would split any profits,
two-thirds of which would go to the New York Fed.
Over the weekend of March 1, 2009, came the announcement that the fed-
eral government would supply AIG with $30 billion in cash in anticipation of

the firm’s forthcoming report of a $61.7 billion loss for the fourth quarter of
2008. The government also eased the terms of its prior capital injections by
converting preferred shares into stock that did not carry a required minimum
dividend, which relieved AIG of having to pay a 10 percent dividend on the
preferred shares. The government retained its ownership interest in AIG, while
taking a secured interest in the company’s more valuable divisions.
Fed chairman Bernanke had some harsh words for AIG in testimony before
Congress on March 3, 2009, stating:
AIG exploited a huge gap in the regulatory system. There was no oversight of the
financial products division. This was a hedge fund, basically, that was attached to
a large and stable insurance company, made huge numbers of irresponsible bets,
took huge losses. There was no regulatory oversight because there was a gap in the
system.13
Not long after taking office, President Barack Obama said in an appearance
on the Tonight Show:
You’ve got a company, AIG, which used to be just a regular old insurance company.
. . . Then they decided—some smart person decided—let’s put a hedge fund on
top of the insurance company and let’s sell these derivative products to banks all
around the world.14
The Fed was under attack for withholding the names of AIG counterparties
who were receiving funds from the government for collateral calls on AIG
derivatives, but the names quickly leaked out, forcing AIG to issue its own
list. Foreign bank recipients included Deutsche Bank ($12 billion), Société
Générale ($12 billion), Barclays ($8.5 billion), and UBS ($5 billion). Several
large U.S. investment banks had received payment in full on their transactions
with AIG. Goldman Sachs had contributed greatly to the run on the bank at
AIG by demanding billions of dollars in collateral as AIG’s position declined.
Goldman received an additional $2.6 billion from the government bailout for
those swaps. It also sold $5.6 billion of the CDOs underlying some of those
swaps to the government for $5.6 billion, their full value.
Goldman Sachs received some $13 billion from the AIG rescue, raising
questions in the press as to why the taxpayers were paying to protect one of
the richest and most sophisticated firms on Wall Street. Its close connections
to Paulson and other members of the recently departed Bush administration
were also criticized. Other American institutions receiving payment in full
from the bailout were Merrill Lynch, $6.8 billion; Bank of America, $5.26
billion; Citigroup, $2.3 billion; and Wachovia, $1.5 billion.
Greenberg was critical of those payments, contending that the counterpar-
ties should not have been paid in full from government funds and that it was
simply a gift to those large banks. He believed that AIG should have been
put in bankruptcy and that these payments should have been renegotiated as
a part of its reorganization. Greenberg saw the government’s rescue of AIG

as a failed strategy. Rather, he recommended that the government reduce its

stake in AIG from 80 percent to 15 percent and ease loan terms so that the firm
could raise private capital. Greenberg was also critical of the initial interest
rate charged by the government for its infusions, which was 850 basis points
over LIBOR, comparing favorably to the subprime rates previously enjoyed
by predatory lenders.
More Failures
Merrill Lynch
Merrill Lynch was one of the largest and most staid investment banks on Wall
Street. Charles Merrill started it in 1914, assisted by his college roommate,
Edmund Lynch. The firm grew quickly, and in the 1920s specialized in under-
writing for chain stores. Merrill’s firm survived the stock market crash of 1929
and the Great Depression and grew steadily over the years. By the 1950s, it
was the leading firm on Wall Street, with offices in more than a hundred cities
and 400,000 customers. It was then almost twice the size of its next-largest
competitor, Bache. Because of its size, Merrill Lynch was referred to on Wall
Street as the “thundering herd” and “we the people.”
Merrill’s public image was greatly enhanced by its nationwide advertising
campaign during the political turmoil in the 1970s, which featured the slogan
that Merrill Lynch was “Bullish on America.” Under the leadership of its CEO,
Donald Regan, later treasury secretary and controversial White House chief of
staff under the Reagan administration, Merrill Lynch diversified into a broad
array of financial businesses and expanded its operations worldwide.
Merrill Lynch had taken a few hits before the subprime crisis. It faced a
serious challenge in 1980 during the “silver crisis” that posed a systemic risk
before its resolution. That crisis emerged after the Hunt family of Dallas failed
to meet margin calls on their massive silver futures positions held at various
broker-dealers. Under the rules of the commodity futures exchanges, those
broker-dealers became liable for the Hunts’ margin calls. Merrill Lynch and
Bache faced losses of several hundred millions of dollars, and it appeared for
a time that Bache might even fail. It was feared that Bache’s demise would
cause other failures and lead to a financial crisis. The silver crisis ended after
a consortium of banks made a $1.1 billion loan to the Hunts. Paul Volcker,
then the Fed chairman, blessed that loan, which saved brokerage firms from
losses on their Hunt positions. Merrill Lynch received over $425 million of
that loan.15
No stranger to the vagaries of the residential real estate market, Merrill had
made an unsuccessful attempt to enter that market in the 1970s. In 1978 Merrill
Lynch bought American Mortgage Insurance Company (AMIC), which sold
credit insurance on residential first mortgages. Merrill Lynch soon found that
business was not to its liking and sold it to a group of AMIC executives in

1981. The firm also acquired more than twenty real estate agencies but later
exited that business as well.
Securitizations of mortgages had caused problems at Merrill Lynch before
the subprime crisis. In 1987, a Merrill Lynch trader, Howard A. Rubin, was
found to have concealed losses from collateralized mortgage obligations
totaling $377 million. Rubin was fired by Merrill Lynch and was suspended
from the securities business for nine months by the SEC. He was then hired
by Bear Stearns and became the head of its mortgage department. Mortgage
underwritings at Bear Stearns grew from $7 billion in 1988, after Rubin ar-
rived, to $41 billion in 1992.
Merrill Lynch faced another crisis due to derivatives when Orange County,
California, declared bankruptcy in 1994, after losing nearly $2 billion in a
$7.6 billion investment fund. Robert Citron, the Orange County treasurer, had
leveraged the fund through borrowings and derivatives, betting that interest
rates would fall. That wager was hugely successful until Alan Greenspan raised
interest rates unexpectedly in 1994, causing large losses in Citron’s positions
and bankrupting the county. Orange County sued Merrill Lynch for advising
Citron to make investments that breached state-imposed trading limits. Mer-
rill Lynch agreed to pay $400 million to settle this and other claims arising
from that debacle.
The firm faced other challenges as well. It appeared to have lost its market
power as a result of competition from discount brokers offering electronic execu-
tions during the stock market bubble at the end of the twentieth century. Merrill
Lynch faced more difficulties after the stock market bubble burst in 2000. Its
profits were in decline and expenses were growing, a troubling business model.
E. Stanley O’Neal was placed in charge of a cost-cutting effort to restore Merrill
Lynch to profitability. He was ruthless, firing 23,000 employees, including 37
percent of the firm’s brokers. O’Neal converted Merrill’s brokerage activities
from one-on-one customer contacts to call centers in order to cut costs. He also
closed 150 of Merrill’s 750 offices and shuttered its operations in Japan and
Canada. O’Neal was promoted to the positions of CEO and chairman of Merrill
Lynch in December 2002 because his cost cutting appeared to be paying off.
Merrill Lynch posted $4 billion in profit for 2003, and the company announced
record earnings in 2004, allowing it to announce a buyback of $4 billion worth
of its own stock. O’Neal was paid $28 million for his work in 2003.
O’Neal had come a long way. He was the grandson of a slave, and his
family home had no indoor plumbing or running water until they moved to a
federal housing project in Atlanta, where his father was able to find a job on
an assembly line at a General Motors (GM) plant. O’Neal found work at that
same plant and paid his way through college under a work-study program at
the plant. He then obtained an MBA at Harvard and worked his way up to
become head of the GM Treasury division.
After joining Merrill Lynch in 1987, he spent the next twenty-one years
there in various positions, including CFO, before taking control of the firm.

During his tenure as CEO, between 2002 and 2006, Merrill Lynch’s annual
earnings rose from $18.3 billion to $32.7 billion; shareholder return on equity
tripled; and Merrill’s stock price rose from $28 per share to $97. Merrill Lynch
was on a roll in 2005 and 2006. Its fourth-quarter 2005 earnings were up by
25 percent over the prior year, and Stan O’Neal was given $35.5 million in
compensation as a reward.
Merrill Lynch experienced a 44 percent increase in earnings in the second
quarter of 2006. Its profits doubled as a result of the sale of its asset manage-
ment group to BlackRock in the third quarter of 2006, and earnings for the
fourth quarter of 2006 rose by 68 percent over the prior year. Again O’Neal
was well rewarded, earning $48 million for his services in 2006. O’Neal was
also generous to other executives. In total, Merrill Lynch paid out $7.5 billion
in bonuses to its executives for their performance in 2006. One trader on a
salary of $350,000 was paid a bonus of $35 million.
O’Neal made the fateful decision that Merrill Lynch should make an ag-
gressive push into the subprime market. He replaced the existing manager of
Merrill’s mortgage business with Michael Blum, and a new trader, George Da-
vies, was hired to increase the volume of subprime loans handled by Merrill’s
trading desk. In order to entice mortgage originators to sell it loans, Merrill
Lynch provided them with warehouse loans at below-market rates.
Merrill Lynch became even more deeply involved in the subprime mort-
gage market when it purchased First Franklin Financial Corporation from
National City Corporation in September 2006 for $1.3 billion. National City
had bought First Franklin from Bank of America in 1999 for $266 million.
Based in San Jose, California, First Franklin was one of the nation’s leading
subprime mortgage companies, originating more than $29 billion in loans in
2005. A company press release quoted a Merrill Lynch spokesman as saying
that this acquisition “will add scale to our platform and create meaningful
synergies with our securitization and trading operations.” He did not mention
that it would also destroy the firm.
In order to further boost its presence in the mortgage market, Merrill Lynch
purchased twelve residential and commercial mortgage entities between Janu-
ary 2005 and January 2007. By 2007, Merrill Lynch was ranked first, with
Citigroup second, as the leading CDO issuer in the United States. Merrill
Lynch issued $33.4 billion in CDOs in the first half of 2007, a nearly 50 percent
increase over the previous year. The Wall Street Journal printed a front-page
report on the complexities of one of the CDOs created by Merrill Lynch called
Norma CDO I after several of its payment classes were downgraded by ratings
agencies from investment grade to junk.16
Merrill Lynch had some $70 billion of exposure on its books from sub-
prime mortgages in 2007. Like UBS and others, Merrill Lynch risk managers
thought that the higher-rated tranches in the CDOs would be unaffected by any
predicted slump in the housing market. As O’Neal testified before Congress,
after large losses were sustained at Merrill, he believed that Merrill Lynch

held subprime securities that carried only “low risk.” Merrill Lynch even tried
to offset some of what it thought was low risk through monoline insurance
companies (see Chapter 9). Merrill Lynch also hedged some of the risk of its
CDO exposures with AIG, but AIG withdrew from that arrangement in 2005.
Merrill Lynch continued to invest in subprime CDOs even though its hedging
protection was reduced.17
O’Neal’s strategy appeared to be paying off into the first half of 2007. Merrill
Lynch had large trading gains and reported a 40 percent increase in earnings
in the first quarter of 2007. Merrill Lynch’s income increased by 31 percent in
the second quarter of that year over that of the prior year. That robust growth
ended in the third quarter when the firm began showing some signs of serious
damage. Merrill Lynch had predicted a $4.5 billion write-off in that quarter
for CDOs and other subprime mortgage exposures. The actual write-off was
$7.9 billion, resulting in a loss of $2.3 billion for the quarter, the largest-ever
quarterly loss for a Wall Street brokerage firm.
Merrill Lynch’s credit rating was downgraded, which was a major blow to
the firm because, as an investment bank, it depended on market acceptance of
its credit. The price of the firm’s stock dropped sharply after these events. As
the enormity of Merrill Lynch’s exposure to subprime mortgage risks began
to surface, two senior executives were fired, Osman Semerci and Ahmass L.
Fakahany. The two men were responsible for overseeing the subprime in-
vestments that caused Merrill Lynch some $5.5 billion in losses before their
departure. Christopher Ricciardi, the executive responsible for leading Mer-
rill Lynch into the subprime CDO market, had already left the firm to take a
position at another firm.
O’Neal was fired in October 2007, after he failed to inform the Merrill Lynch
board that he had been seeking a merger with Wachovia bank as Merrill’s
losses mounted. That action made it appear that O’Neal was both desperate
and out of touch with his board. To ease his pain, O’Neal was given a $161
million retirement package. That payout aroused controversy because it gave
the appearance that O’Neal was being rewarded for his leading the firm into
its subprime meltdown.
The next CEO was John Thain, a former partner at Goldman Sachs and, more
recently, CEO of NYSE. Despite the $15 million signing bonus he received to
join Merrill Lynch, Thain proved to be no savior. Indeed, it soon became clear
that the wheels had come off the O’Neal profit machine after Merrill Lynch
announced another record loss, $9.83 billion for the fourth quarter of 2007.
Merrill Lynch wrote off almost $15 billion in assets in the fourth quarter, in-
cluding $9.9 billion for CDOs, $1.6 billion for subprime mortgages, and $3.1
billion for expected defaults by bond insurers on Merrill Lynch’s exposure
on credit obligations. Merrill reported a net loss for 2007 of $8.6 billion. It
also announced that it was restating its cash flow statements for a period of
three years. The company had erroneously classified several billion dollars
in those statements.

The first quarter of 2008 was a bit better, but Merrill Lynch still reported a
$1.96 billion loss in that quarter as the result of another $6.6 billion writedown
on its subprime investments. By then, Merrill Lynch had written off more than
$30 billion as a result of mortgage problems. Those writedowns far exceeded
the $22 billion in profits made by Merrill Lynch under O’Neal’s leadership
between 2002 and 2006. Merrill Lynch’s second-quarter results in 2008 showed
the loss of $4.9 billion after taking writedowns of $9.7 billion. This was the
firm’s fourth consecutive quarterly loss. In the previous twelve months, it had
lost more than $19 billion. Total writedowns over the previous year had risen
to exceed $41 billion. By the end of August 2008, Merrill Lynch’s losses over
the preceding year and a half equaled the amount of profits it made since it
went public in 1972.
To deal with this crisis, Merrill Lynch announced the elimination of 4,000
jobs. Thain also sought to shore up Merrill Lynch’s capital base by selling
$6.2 billion of its stock to a sovereign wealth fund in Singapore (Temasek
Holdings) and to a mutual fund manager (Davis Selected Advisers). That stock
was sold to those investors at a 12 percent discount, but that proved to be no
bargain, and they would come to regret the investment.
In order to raise more cash, Merrill sold its 20 percent ownership interest in
Bloomberg for $4.425 billion. It also sold more than $30 billion in mortgage-
related assets for a fire-sale price of $.22 on the dollar. Merrill Lynch also
provided financing for the sale and provided some loss protection. After that
sale, Merrill Lynch reported the writedown of $5.7 billion on its books for those
assets and a return to the market to raise another $8.5 billion in capital.
Merrill Lynch was on the ropes and looking for a rescue as the Lehman
Brothers crisis unfolded. Having walked away from acquiring Lehman after
government guarantees were refused, Bank of America then made the stun-
ning decision on September 15, 2008, to acquire Merrill Lynch and its 60,000
employees in exchange for $50.3 billion in Bank of America stock. Merrill
Lynch had written down assets by $52 billion by the time of its acquisition. In
its last stand-alone quarterly report, the firm announced that it had lost another
$5.15 billion, evidencing why it needed a rescue. On November 7, 2008, Merrill
Lynch also announced the sale of an additional $4 billion in mortgage-backed
securities and related instruments on its books. By then, Merrill Lynch had
sustained losses of $35.8 billion in eighteen months.
The merger with Merrill Lynch made Bank of America the largest broker-
age firm in the world, with more than $2.5 trillion in client assets. The merger
was unsuccessfully challenged on various grounds in both state and federal
courts. The County of York Employees Retirement Plan in Pennsylvania also
mounted a challenge, a suit that was settled by an agreement that Merrill
Lynch would make additional disclosures on why it had declined to bring
legal action against its former officers and directors in connection with the
firm’s CDO investments and whether it had too hastily agreed to the merger.
Those disclosures added nothing to the mix, and the only real result was that

the plaintiffs’ lawyer fees were paid at Merrill Lynch and Bank of America’s
expense as a part of the settlement.
Bank of America incurred a loss of $1.79 billion for the fourth quarter of
2008, due largely to unexpected losses at Merrill Lynch, totaling $15.3 billion.
The merger nearly fell apart after Bank of America learned of these unexpected
losses. Bank of America CEO Kenneth Lewis tried to walk away from the
deal on December 17 before it closed. However, Fed chairman Bernanke
protested, and Lewis was warned by the Fed that walking away from the deal
would undermine the confidence of the government in Bank of America’s
management and that the government might insist on removing the bank’s
officers and directors. In addition to this naked display of power, according to
Lewis, Paulson and Bernanke directed him not to publicly disclose Merrill’s
impending losses until after the deal was closed.18
Thereafter, on January 14, 2009, it became known that Bank of America
had received an additional $20 billion from the Treasury Department’s bailout
program in order to close the merger with Merrill Lynch. The Treasury and the
FDIC also agreed to protect Bank of America from any unusually large losses
on a pool of residential and commercial real estate loans valued at $118 billion.
Bank of America was required to absorb the first $10 billion in losses on those
assets, but the government would pay for 90 percent of any losses beyond that
amount. In exchange for that assistance, Bank of America issued $4 billion
in preferred shares to the Treasury Department and to the FDIC, which paid
an 8 percent dividend totaling about $320 million a year, plus an additional
fee of $236 million per year. Bank of America also agreed to comply with
enhanced executive compensation restrictions and to implement a mortgage
loan modification program.
The acquisition of Merrill Lynch undercut Lewis’s credibility, as it appeared
that Bank of America had significantly overpaid for Merrill Lynch. Bank of
America announced the elimination of 35,000 positions over the next three
years as a result of the merger. More embarrassment followed as a result of a
dispute with Thain. Thain was paid $83.1 million for his work at Merrill Lynch
during 2007, even though he did not succeed in saving the firm. He sought an
additional $10 million bonus in 2008 after Merrill Lynch was taken over by
Bank of America. That request drew widespread criticism considering that the
company had failed during Thain’s reign, and he was sharply criticized over
the unexpected $15.3 billion loss in the fourth quarter. Those losses proved to
be highly controversial, especially because a bonus pool of more than $4 bil-
lion was to be paid to some Merrill Lynch executives despite the losses. There
was another problem. A Merrill Lynch currency trader, Alexis Stenfors, was
under investigation for trading losses of $400 million that he had kept hidden.
Stenfors had reported a personal trading profit of $120 million in 2008.
The Bank of America board of directors rejected Thain’s bonus request,
after Andrew Cuomo stated that bonuses for Thain, or anyone else at Merrill
Lynch, were unjustified. Cuomo launched an investigation of those bonuses to

determine whether proper disclosures of the bonuses had been made. He made
further headlines after he reported that 700 Merrill Lynch employees had been
given bonuses of $1 million or more for 2008. However, Merrill Lynch had
39,000 other employees who were not given bonuses at that level.
On January 22, 2009, Lewis fired Thain, who had appeared rather insensi-
tive about the losses at Merrill Lynch by leaving for a two-week vacation in
Vail when the massive fourth-quarter loss was reported. Thain caused further
annoyance by accelerating the already controversial bonus payments to Merrill
Lynch employees. He was also reported to have redecorated his office at a cost
of $1.2 million. That renovation included a $35,000 commode and an $87,000
area rug. Thain offered to repay Merrill Lynch for those costs, and he went
on TV to blast Bank of America, stating that bank officials were fully aware
of the acceleration of the bonuses and of the large losses before they became
public. Indeed, the Financial Times of London reported in March 2009 that
Bank of America had been the one pushing for some of the large writedowns
that caused the unexpectedly large fourth-quarter loss at Merrill.
In a front-page article on March 4, 2009, the Wall Street Journal charged that
the top ten earners at Merrill Lynch had made $209 million in 2008. However,
much of that compensation was in stock, which had declined sharply in value.
Two of the larger packages went to Peter Krause and Thomas Montag, high-
profile recruits that Thain had brought over from Goldman Sachs to restore
Merrill Lynch. They gave up high-paying positions at Goldman, as well as
Goldman stock, in order to come to Merrill, but they were well rewarded for
their move.19 Montag was given a guaranteed package of about $50 million.
Krause was to receive as much as $25 million under the terms of his golden
parachute contract triggered by the takeover of Merrill Lynch by Bank of
America. He had worked at Merrill Lynch for only about three months.
On October 6, 2008, Bank of America announced the reduction of its divi-
dend and the raising of $10 billion in new capital. The bank reported in January
2009 that it would defer bonuses for its own employees in its capital markets
divisions. The bank planned to pay their 2008 bonuses in increments of one-
third in February 2010, and one-third in both 2011 and 2012. Of course, that
did not please the Bank of America employees who saw the outsize Merrill
Lynch bonuses as a slap in the face.
Lewis encountered other problems. Bank of America shareholders approved
a proposal, at the bank’s annual meeting in April 2009, recommending the split-
ting of Lewis’s role as both CEO and chairman, which the bank did after the
vote. Such votes were highly unusual. The government later sought to shake
up the bank’s board after it concluded that Bank of America needed to raise
an additional $33.9 billion in capital. The government also wanted the bank
to bring in individuals with more bank experience to serve as board members,
and the board makeup was changed in response to that request.
Adding insult to injury, the SEC filed suit against Bank of America charg-
ing that the bank had misled shareholders with respect to the bonuses paid

to the Merrill Lynch employees in order to gain their vote on the approval
of the merger. The bank’s outside lawyers advised that such disclosure was
not required before the shareholder vote on the takeover. The SEC disagreed,
and Bank of America agreed to settle that suit for $33 million, but the federal
judge hearing the matter, Jed S. Rakoff, questioned whether the settlement
was adequate. The judge was scathingly critical of the fact that no individual
executives or outside lawyers (who had advised that disclosure was unneces-
sary) were sued for failing to make the disclosures. The SEC asserted that it
was handicapped because the information it needed to act against the execu-
tives and lawyers was protected by attorney-client privilege. In a reprise of
the Enron-era abuses, Judge Rakoff responded by sharply criticizing the SEC
for not demanding that the bank waive attorney-client privilege.
Rakoff rejected the settlement, criticizing the SEC for imposing a fine on
Bank of America shareholders, rather than the individual culprits. The judge
even quoted Oscar Wilde in his opinion. Judge Rakoff did later, reluctantly,
approve a revised $150 million settlement (up from the original $33 million
settlement) to be paid by the bank from shareholder assets. The judge wanted
the funds distributed to shareholders injured by the lack of disclosures, many
of whom would probably be the ones still holding the stock and who would
be simply repaying themselves.
Cuomo, for some unknown reason, opened a separate investigation of these
same events and also demanded a waiver of the attorney-client privilege. He
sought to determine why the Bank of America general counsel was fired after
discussing the unexpected losses at Merrill Lynch with a Bank of America
risk manager. As the Rakoff opinion became public, Cuomo’s office leaked its
intention to sue Lewis, as well as Bank of America’s CFO, Joseph Price. More
controversy, and weirdness, followed after Representative Edolphus Towns
(D-NY), the chairman of the House Oversight and Government Reform Com-
mittee, demanded that Bank of America waive its attorney–client privilege. He
also asserted that the privilege was not available for congressional investiga-
tions. At that point, on September 30, 2009, Lewis announced his resignation
from the bank, and the bank, thereafter, agreed to waive its attorney–client
privilege for the contested issues. Subsequently, Cuomo and the North Carolina
attorney general filed separate suits against Bank of America and its CEO Ken-
neth Lewis. Those actions charged fraud in failing to disclose the unexpected
losses at Merrill Lynch before the shareholder vote to approve its merger with
Bank of America. The Obama administration’s pay czar, Kenneth Feinberg,
also demanded that Lewis forgo any bonus in 2009 and return $1 million that
he had already received in 2009. Feinberg made that demand because Lewis
was receiving a $69.3 million retirement package.
After this dustup, Bank of America was unable to find a replacement for
Lewis, and the bank was left rudderless for several months as candidate after
candidate refused to accept the payment terms demanded by Feinberg. Robert
Kelly, the CEO at the Bank of New York Mellon, was about to accept the job

but changed his mind because of the compensation issue. In December 2009,
Bank of America announced an agreement with the government to repay the
$45 billion in bailout funds so that it could regain control of the company
and set its own compensation policies. Nevertheless, Feinberg expressed op-
position to any large compensation package for a new CEO. The bank then
gave up its hunt for an outside CEO and hired internally, selecting Brian T.
Moynihan as its new head.
The Crisis at Morgan Stanley
Morgan Stanley, another investment bank badly damaged by the subprime

crisis, was the investment banking branch of the J.P. Morgan firm that was
separated from J.P. Morgan’s commercial banking operations as a result of the
passage of the Glass-Steagall Act in the 1930s. The Morgan in Morgan Stanley
was Henry S. Morgan, the grandson of J.P. Morgan. Morgan Stanley quickly
captured significant market share and was considered among the more staid
of the white-shoe investment banks. However, Morgan Stanley surprised Wall
Street with the announcement of a merger with the Dean Witter brokerage firm
in 1997. In Morgan Stanley circles, Dean Witter was seen as a comparatively
lowbrow retail brokerage operation.
The merger created a financial colossus with more than 600 offices world-
wide and some 45,000 employees. Assuming control of the combined firm
was Philip Purcell, from the Dean Witter side, which created a schism between
the investment bankers from Morgan Stanley and the more down-to-earth
retail brokers at Dean Witter. Purcell also faced a number of regulatory and
litigation problems. The SEC charged that the firm had inflated the value of
its mark-to-market accounting for assets on its balance sheet in 2000. Ironi-
cally, it was mark-to-market accounting that was at the heart of the subprime
crisis at Morgan Stanley. More significantly, Purcell had to contend with the
Enron-era financial analyst and mutual fund scandals.
An attack by investment bankers on Purcell began in earnest after Morgan
Stanley became involved in a brawl in the Florida courts with Ronald Perel-
man. Perelman was unhappy with Morgan Stanley’s representation of Sun-
beam, in which Perelman had taken a large stake. Morgan Stanley suffered
a number of embarrassing setbacks in that litigation over issues concerning
its good faith in the discovery process. The problem escalated after a Florida
jury awarded Perelman $1.57 billion in damages. However, that verdict was
set aside on appeal.
Purcell was under fire pending appeal of the Perelman verdict, and he
came under further criticism for his $22 million compensation package in
2004. He was thereupon targeted by a group of Morgan Stanley alumni who
were complaining about the firm’s lagging stock price. The California Public
Employees’ Retirement System (CalPERS) and other state employee pension
funds joined them. In 2005 he was forced out and given a $43.9 million sever-

ance package, plus $40 million from sales of about 20 percent of the shares of
Morgan Stanley stock that he owned, plus a $250,000 annual pension for life.
Morgan Stanley further agreed to make $250,000 in charitable contributions
to charities of Purcell’s choice.
John Mack, who had been pushed out of the firm earlier by Purcell, returned
to take charge of Morgan Stanley with a $60 million compensation package.
Mack had been paid $26 million while at Morgan Stanley in 1999—the same
amount that Purcell had received that year. However, after criticism in the press
of his and other pay packages at Morgan Stanley, Mack renounced his compen-
sation package in favor of one based on performance. He was also caught up
in a scandal at the SEC. An SEC attorney, Gary Aguirre, claimed that he was
fired after he insisted that Mack be subpoenaed to testify in an insider-trading
investigation, which involved trading at Pequot Capital Management, a hedge
fund where Mack had worked before returning to Morgan Stanley.
The SEC inspector general investigated the matter and reported that officials
at the SEC had engaged in misconduct by revealing information about the
investigation to Morgan Stanley representatives and recommended disciplin-
ary action. The matter was then assigned to an administrative law judge at the
SEC, who concluded that there had been no misconduct by those staff officials
and no action was taken against Mack. The investigation of Pequot dragged on
for some time, however, undermining confidence in that once popular hedge
fund and leading to its closure in May 2009. The SEC subsequently reopened
its investigation and entered into a settlement with Pequot in which Pequot
and its manager Arthur Samberg agreed to pay $28 million. The SEC, in turn,
agreed in June 2010 to pay $755,000 to Gary Aguirre to settle his claim of
wrongful termination.
Like Merrill Lynch, Morgan Stanley had reported large profits before the
subprime crisis. Mack was paid $41 million for his work during 2006. In 2007,
Mack spun off its Discover credit card operations in order to help raise the
value of the Morgan Stanley stock, and the firm had had record profits in the
first two quarters of that year. However, Morgan Stanley announced a $3.59
billion writedown in the third quarter of 2007 due to subprime-related losses
and a reduction in earnings of 7 percent over the same quarter in the previous
year. For the first nine months of 2007, Morgan Stanley still had record profits,
which increased 41 percent compared with the previous year. Nevertheless,
the third-quarter writedown was troubling because Morgan Stanley was not
viewed as a large player in the subprime market.
Any doubt that Morgan Stanley had large exposures to subprime instru-
ments vanished after the firm sustained a shocking $3.9 billion loss in the
fourth quarter of 2007 on additional writedowns of $9.4 billion on subprime
mortgage investments. This was Morgan Stanley’s first quarterly loss in its
seventy-two-year history. Zoe Cruz, the highest-ranking woman on Wall Street,
was fired by Mack as co-president of Morgan Stanley after the enormity of its
subprime exposure was revealed. In order to shore up its capital, Mack arranged

to sell about 10 percent of Morgan Stanley to China Investment Corporation,

a Chinese sovereign wealth fund, for $5 billion. That seemed to help stabilize
the situation but, in fact, worse was yet to come.
Morgan Stanley reported better-than-expected results for the first quarter
in 2008, but earnings were still down by 42 percent over the prior year, and
it had to take a $1.2 billion loss due to mortgage trading activities. By April
2008, Morgan Stanley had written off $12.6 billion in bad assets. The firm’s
second-quarter profits fell by 60 percent over the prior year. A massive run
on Morgan Stanley’s stock in the third quarter seems to have been spurred by
trading in CDSs by several large firms including Merrill Lynch, Citigroup,
Deutsche Bank, and UBS. The rising cost of those swaps evidenced a concern
in the market as to the viability of Morgan Stanley and undermined faith in
the firm, though it was unclear whether those large firms were hedging their
exposure to Morgan Stanley or simply speculating and causing a panic in the
stock of a competitor.
Pressure on the Morgan Stanley stock was furthered by rumors in the mar-
ket that Deutsche Bank had withdrawn a $25 billion line of credit to the firm.
Morgan Stanley’s clearing bank, the Bank of New York Mellon, demanded an
additional $4 billion in collateral. Hedge funds reportedly sought to withdraw
$100 billion in assets as a result of concerns over Morgan Stanley’s financial
condition.
Morgan Stanley lost about one-third of the assets that it held for hedge funds
and other large investors as their prime broker. Those funds were moved to
the largest banks because of a general belief that the government would not
let those banks fail. The hedge funds were also annoyed at a memorandum
issued by Mack that blamed short-sellers for the attack on the Morgan Stanley
stock.
In 2007, Morgan Stanley had $782 billion in assets under management, but
by September 2008 that number had shrunk to $582 billion. There was some
good news. On September 16, 2008, Morgan Stanley reported that it expected
better third-quarter profits, as did Goldman Sachs. However, the stock of both
companies dipped the next day after the failure of Lehman Brothers, and after
the breaking of the buck at the Reserve Primary Fund. The price of Morgan
Stanley stock fell by 24 percent on that day, while that of Goldman Sachs stock
fell by 14 percent. The Dow plunged by 449 points, pushing it 23 percent be-
low its level of one year earlier. The Treasury Department sold $40 billion in
Treasury securities as investors sought safety. Some panicked investors bought
Treasury notes at prices that would assure a loss on the investment.
On September 17, 2008, Mack began merger talks with Wachovia in an
effort to save Morgan Stanley from failure, as O’Neal had tried a year ear-
lier in his attempt to rescue Merrill Lynch. However, Wachovia had its own
problems and failed spectacularly not long after those talks. In desperation,
Mack decided to transform Morgan Stanley from a broker-dealer primarily
regulated by the SEC into a bank holding company that would fall under the

umbrella of bank regulators, a regulatory change that had been denied to Leh-
man Brothers. In that capacity, Morgan Stanley could gain access to govern-
ment funds that would provide it with liquidity. It would also allow Morgan
Stanley to issue trust-preferred securities that would serve as Tier 1 capital
for regulatory purposes. That transformation was carried out, and it restored
faith in the firm, allowing Morgan Stanley to survive the storm touched off
by the Lehman Brothers failure.
Nevertheless, Morgan Stanley remained under threat during the week of
October 6, as rumors circulated that a deal to raise capital from Japan’s larg-
est banking group, Mitsubishi UFG Financial Group (MUFG), might falter.
Morgan Stanley’s stock price suffered as a result of those concerns, but MUFG
agreed to buy 20 percent of Morgan Stanley for $9 billion. That ownership stake
was kept under 25 percent because exceeding it would subject MUFG to U.S.
regulatory oversight. Mitsubishi also agreed not to exercise any controlling
influence over Morgan Stanley’s management policies. Morgan Stanley stock
price rose by 78 percent after this capital injection was confirmed. The federal
government announced over the October 11 weekend that it would protect the
investment by Mitsubishi in Morgan Stanley. The Treasury Department agreed
that it would not wipe out that investment if it injected capital into Morgan
Stanley at some later point. These assurances were needed in order to secure
the Mitsubishi investment.
Morgan Stanley’s shares recovered after the completion of the MUFG
investment was announced, but the firm laid off about 2,300 workers. Mack
and his two top lieutenants agreed to forgo bonuses for 2008—the second year
that Mack had not received a bonus. Morgan Stanley reported a loss of $2.3
billion in its fiscal fourth quarter, which ended in November 2008. The loss
was due primarily to a further $2 billion in writedowns. However, Morgan
Stanley was able to report a profit for the full fiscal year 2008.
Washington Mutual (WaMu)
Another large failure loomed at Washington Mutual (WaMu), where large

subprime exposures undermined its viability. WaMu, a Seattle-based savings
bank founded in 1889, had weathered the Great Depression as well as the sav-
ings and loan crisis in the 1980s. It entered the subprime market in 1999 with
the purchase of Long Beach Financial and then began an aggressive expansion
into subprime lending. One of its advertising slogans was “The Power of Yes,”
signifying its willingness to make risky loans. It also adopted the slogan “The
Bank of Everyday People.” WaMu’s mortgage lending increased from $700
million in 2002 to $2 billion in 2003, and the bank increased the number of
its branch offices by 70 percent during that period. At its peak, WaMu had
2,200 branch offices operating in thirty-eight states. WaMu was particularly
aggressive in promoting option adjustable-rate mortgages (option ARMs),
which constituted about 70 percent of its mortgage loans by 2006.

WaMu problems began to surface after it reported a $1.87 billion loss in the
fourth quarter of 2007. The bank then stopped subprime lending, but too late.
It reported a $1.14 billion loss in the first quarter of 2008, boosted its loan loss
reserves to $3.5 billion, eliminated 3,000 jobs, and cut its dividend. WaMu
took the role of chairman away from its CEO, Kerry Killinger, a position he
had held for seventeen years, before firing him in September 2008 as losses
continued to mount. By then WaMu had $19 billion in losses. In compensa-
tion for the last nine years of work at WaMu, Killinger had been paid a total
of $123 million, including $10 million in 2007.
JPMorgan tried to buy WaMu in March 2008 for between $7 billion and
$9 billion. WaMu turned down that proposal in favor of a $7 billion capital
infusion from TPG, a private equity group, and others, an investment that it
would come to regret. WaMu depositors withdrew more than $16 billion in
one ten-day period during the market panic in September that followed the
Lehman Brothers failure. Bank regulators seized WaMu on September 25,
2008, in the largest bank failure in U.S. history. Bank regulators arranged a
sale of its operations to JPMorgan Chase for $1.9 billion. The private equity
group headed by TPG was expected to lose its entire investment. The purchase
of WaMu by JPMorgan also failed to rally the markets. The Dow experienced
another sell-off on September 26, 2008.
Wachovia
Before its collapse in 2008, Wachovia had some 15 million customers being
served from 5,000 offices. It was the fourth-largest bank in the United States
in terms of assets and the third largest as measured by the amount of deposits
in 2007. Wachovia was a North Carolina bank that traces its history back to
1879, when the Wachovia National Bank was opened. Wachovia Loan and
Trust was created in 1893. Those two organizations merged in 1911 to form
Wachovia Bank and Trust, which became the Wachovia Corporation.
Wachovia merged in 2001 with First Union, another giant North Carolina
bank. In 2003, Wachovia and Prudential Financial (Prudential) combined their
retail brokerage services and operated under the name Wachovia Securities.
Wachovia purchased A.G. Edwards, another large brokerage firm, in 2007 for
$6.8 billion. That acquisition created a combined retail brokerage firm with
$1.1 trillion in customer assets. Wachovia also bought SouthTrust Corporation
for $14.3 billion.
The firm was able to digest that growth but made a fatal mistake in 2006
when it purchased the Golden West Financial Corporation (Golden West).
Based in Oakland, California, Golden West dated back to 1912. It was the
nation’s second-largest savings and loan association and a leader in subprime
lending. Golden West marketed its mortgages through World Savings Bank,
which it owned. Wachovia purchased Golden West for $26 billion, at a 15
percent premium over its market price. At the time of this acquisition, Golden

West was managed by Herb and Marion Sandler, a husband and wife team of
co-CEOs. The Wall Street Journal called this acquisition a big “gamble” on
the mortgage market by Wachovia—an understatement to say the least.
Wachovia had a 13 percent increase in earnings over the prior year in the
third quarter of 2006 and had good fourth-quarter results. Profitability contin-
ued for a time into 2007, when it had a 24 percent increase in earnings in the
second quarter. However, as a result of subprime writedowns its third-quarter
2007 results showed a decline of 10 percent from the year before. Wachovia
also announced that it would writedown more than $1 billion in commercial
loans in 2007, raising concerns that the subprime crisis was spilling over into
that market. The firm was the leading originator of commercial loans, many
of which were pooled and sold off through special-purpose entities.
It raised $2.3 billion through a conventional preferred equity offering in
December 2007 and $800 million in a trust preferred offering in September
of that year. Earnings in the fourth quarter of 2007 were “poor,” as conceded
by Wachovia, and were the result of $1.7 billion in writedowns. The price of
Wachovia’s stock had dwindled by over 50 percent during 2007. Wachovia
announced a $393 million loss in the first quarter of 2008 and subsequently
reduced its dividend by 41 percent.
The bank was severely embarrassed after it had to increase its previously
announced loss in the first quarter of 2008 by nearly 100 percent because of a
writedown on its life insurance business. Wachovia also advised shareholders
that conditions in the economy were deteriorating more rapidly than expected,
therefore, it needed to bolster its capital. The bank raised $3.5 billion from a
preferred stock offering and sought an additional $7 billion from private equity
investors as the first quarter ended.
Wachovia discontinued the option ARMs, which were a significant mort-
gage product of Golden West, when Wachovia acquired it. Those contracts
provided borrowers with multiple payment choices, including “pick-a-pay”
loans that allow interest-only payments or even payments so small that they do
not even cover the interest. This product was widely copied by other lenders,
including Countrywide and WaMu, both of which surpassed Golden West in
the origination of such loans.
As a result of Wachovia’s losses, Robert Verrone, the head of the bank’s
commercial loan division, was fired, and the bank’s CEO, G. Kennedy Thomp-
son, was stripped of his post as chairman of the board. Thompson lost his
CEO position five weeks later. Lanty L. Smith, Wachovia’s “lead independent
director,” was appointed chairman. As its new CEO, Wachovia hired Robert
J. Steele, a former undersecretary of the treasury, who had led the effort at the
Treasury Department to overhaul the regulatory system dampening American
competitiveness.
Steele was also a former vice chairman of Goldman Sachs, a firm that has
supplied alumni to the highest levels of large financial institutions and the
federal government who were at the center of the subprime crisis, such as

Treasury Secretary Henry Paulson and numerous other officials at the Trea-
sury Department, including Dan Jester and Steve Shafran; Timothy Geithner
hired Mark Patterson from Goldman as his chief of staff when he succeeded
Paulson as treasury secretary. John Thain was president of Goldman before
becoming the CEO of NYSE and then of Merrill Lynch; Duncan Niederauer,
another Goldman alumnus, replaced Thain as head of NYSE; Robert Rubin,
another former treasury secretary, was in a top leadership role at Citigroup;
Stephen Friedman, a former Goldman chairman, was chief economic adviser
to President George W. Bush and chairman of the Board of Governors of the
Federal Reserve Bank of New York; Joshua Bolten became chief of staff to
President Bush; Gary Gensler, undersecretary of the Treasury under Bush,
was appointed by President Obama as chairman of the Commodity Futures
Trading Commission; and Adam Storch was hired from Goldman Sachs to
become managing executive of the SEC’s Division of Enforcement. Paulson
also selected Edward Liddy, who resigned from the Goldman board to head
AIG after its rescue. Robert Zoellick, still another Goldman alumnus, became
president of the World Bank, after Paul Wolfowitz resigned in 2007. Still
another product of Goldman was Jon Corzine, who became a senator from
New Jersey and later its governor, and he became head of MF Global after
losing a Senate race.
Wachovia increased its second-quarter loss in August 2008 from $8.86 bil-
lion to $9.11 billion, which caused its stock further distress. Seeking a merger
partner as a rescuer, it entered into talks with Wells Fargo over the weekend
of September 27. However, Wachovia failed before that merger could be
completed. Wachovia reported that a run on its commercial deposits in the
wake of the fall of WaMu and Lehman and the attendant damage to market
confidence had caused it to fail. CEO Steele told investors—shortly before
its failure—that the bank was in strong enough financial condition to remain
independent.
After its failure, Wachovia announced its takeover for $2 billion by Citi-
group, which benefited by some government inducements to make that offer.
Although Wachovia had a loan portfolio of $312 billion, the government limited
Citigroup’s potential losses to $42 billion. The government would be given
warrants valued at $12 billion for assuming that risk. However, in a surprise
move, Wells Fargo stepped in and took Wachovia away from Citigroup with
a better offer of $15 billion. Citigroup thereupon mounted a counterattack
against Wells Fargo, causing the Fed to step in as a referee. The battle spilled
over into the courts, but the two sides agreed to a truce on October 6, 2008.
The Fed appeared to have brokered a deal to divide the bank between the two
contestants, splitting Wachovia’s branch network between the two banks and
giving Wachovia’s asset management and brokerage business to Wells Fargo.
However, on October 9, 2008, Citigroup walked away from the deal though
it continued its lawsuit for damages.
Wachovia reported a loss of $23.9 billion for the third quarter of 2008, just

before completion of its merger with Wells Fargo. It also announced that Steele
would receive no bonus for 2008. Wachovia’s failure led to the freezing of its
Short Term Fund, used by colleges and private schools as a money market fund
that includes among its investments mortgage-backed securities. Another col-
lege money fund, the Common Intermediate Term Fund, announced on October
2, 2008, that it too was suspending withdrawals, an action that affected some 200
colleges and schools, which had invested a total of $1 billion in that fund.
The Bailout
The Feds Face the Crisis
On September 16, 2008, panic began to spread due to the Lehman Brothers
and AIG collapses. Despite chaos in the market, the Fed refused to cut interest
rates at its meeting that day. LIBOR rates doubled. Reserve banks around the
world pumped billions of dollars into the credit system. The next day, gold
prices rose to $846.60 as investors sought a safe haven, and lending virtually
ceased between banks as well as between banks and consumers as the banks
hoarded cash. The yield on U.S. Treasury securities fell to 0.03 percent, the
lowest level since World War II.
Crude oil prices jumped by $25 a barrel on September 22, 2008, the largest-
ever single-day price increase. Crude oil traded at $130 per barrel, an increase
of about $40 from the previous week. During that week, the commercial paper
market declined by $61 billion and froze on October 2, 2008. Offerings dropped
to the lowest level since such data began to be recorded in 2001, falling by
$95 billion. Automobile sales reached a fifteen-year low in September 2008,
declining by 27 percent compared with the previous year. Vacancy rates at
retail outlets and malls rose sharply in the third quarter.
The average diversified mutual fund lost 10.3 percent during the quarter. The
Dow fell by 16.6 percent during the first three quarters of 2008, while the S&P
500 Index declined by 19.3 percent during that period. Between September
30, 2007, and September 30, 2008, retirement accounts lost about $1.6 tril-
lion. Some 20 percent of workers over age forty-five stopped contributing to
retirement accounts. In another blow to Wall Street, securities underwriting
nearly dried up. Total securities underwriting fell more than 55 percent in the
third quarter from the prior year.
The housing market continued its slump. Housing starts declined by 6.2
percent in August from the prior year, dropping to a seventeen-year low. This
was the third straight month of declines. Housing starts fell by some 70 per-
cent between the peak of the housing boom in January 2006 and September
2008. Housing inventories declined slightly in September 2008 but remained
at historically high levels. By the end of September 2008, residential housing
prices had declined by 19 percent from their peak during the bubble. By then
more than 50 percent of homeowners selling their homes in California had sold

at a loss. Although the number of existing home sales rose in September 2008
(as a result of sales of foreclosed properties at distress prices), the number of
completed foreclosures on homes increased by 8 percent in the third quarter.
The number of houses valued at more than $1 million in foreclosure doubled
between January and August 2008. However, apartment vacancies declined,
though that was only a temporary condition. Mortgages issued in the first six
months of 2007 defaulted at an accelerating pace in the third quarter of 2008.
The default rate exceeded that of mortgages issued in 2006. Default concerns
spurred lenders to obtain guarantees from the Federal Housing Administration
(FHA). The agency guaranteed more than 96,000 mortgages in September
2008, triple the number it had approved in September of the previous year.
Commercial banks nearly shut down their lending activities after the AIG
failure. Despite a package of $180 billion in liquidity provided by the Fed,
and drawdowns of $120 billion from the Fed lending facility, banks and other
financial institutions still did not resume lending. The Treasury contributed
$100 billion to the Fed to support its lending.
The Bailout Bill
On September 17, 2008, Fed chairman Bernanke asked Treasury Secretary

Paulson to support him in an approach to Congress seeking authorization
for funding to support a broader bailout. The following day, the government
leaked its plan to use hundreds of billions of dollars to bail out the holders of
subprime securitizations. The Dow then jumped by 410.3 points and gained
another 368.75 points at the end of that week, putting it at a level of about
where it had started it. Markets worldwide recovered. The commercial paper
market resumed operations. The Fed also cut the Fed funds rate by fifty basis
points on September 19, 2008. In the meantime, the Fed lent out $230 billion,
accepting illiquid asset-backed mortgages as collateral.
The Treasury Department formally released its bailout proposal on Septem-
ber 20, 2008. The plan was only two-and-a-half pages long, but it asked for
$700 billion in discretionary funds. The treasury secretary would be allowed
to use those funds to buy troubled mortgage securities from any company
headquartered in the United States, in any amounts or circumstances in his
own nonreviewable discretion. The proposal also asked that the federal debt
ceiling be lifted to $11.3 trillion.
The Treasury proposal set off a firestorm of criticism in Congress. Demo-
crats wanted more oversight, more relief for mortgage holders, and limits on
the compensation for the executives of companies receiving assistance from
the Treasury under this program. Auto financing companies and small com-
munity banks tried to join the definition of those covered by the rescue plan.
This wrangling caused renewed uncertainty in the market. On September 23,
2008, crude oil prices increased by $16 per barrel and the Dow fell by 372.75
points, closing at 11015.69. Fails-to-deliver Treasury securities in the credit

market rose to an incredible $1.7 trillion on September 24, 2008, up from $420
billion less than two weeks earlier.
Nonetheless, congressional leaders indicated on September 24 that they
had an agreement on a $700 billion bailout. On that same day, Senator John
McCain (R-AZ) announced the suspension of his presidential campaign and
his return to Washington to deal with the ongoing subprime crisis. Talks at
the White House on September 25, 2008, between the president and congres-
sional leaders and the two presidential candidates, however, turned partisan
and were inconclusive, creating an atmosphere of uncertainty over the bailout
legislation. McCain lost a great deal of credibility in making the rather rash
decision to suspend campaigning in order to rush to Washington without a
plan of his own. He also appeared ineffective in the talks at the White House,
which may have cost him the election.
On September 25, 2008, in the midst of one of the worst financial crises
in U.S. history, Cuomo opened an investigation of the CDS market and short
selling, adding to the uncertainty and fear in an already-panicked market.
Ironically, while serving as secretary of housing and urban development un-
der the Clinton administration, Cuomo had been a strong advocate of risky
subprime lending. He imposed subprime quotas on Fannie Mae and Freddie
Mac mandating that at least 50 percent of their products be subprime.
By two days later, a consensus appeared to have been reached on the bailout
bill in Congress. Congressional support seemed to firm up even further the next
day. Front-page news stories on September 29, 2008, prematurely called it a
done deal, considering that the House of Representatives rejected the bailout
plan that same day, by a vote of 228 to 205. That tally was attributed to public
skepticism over the bailout proposal, which directed taxpayer funds to be used
to rescue large financial institutions that appeared to have acted recklessly. After
the House vote, the Dow Jones Industrial Average then suffered the largest
percentage-point drop in its history, falling by 777.68 points.
On September 30, 2008, the Bush administration began to explore alterna-
tives to a bailout bill. One proposal was to raise the FDIC insurance cover-
age levels. Presidential candidates Obama and McCain both supported this
proposal. Obama also advocated expanded regulation and, for no particular
reason, called for an increase in capital gains taxes. However, the Dow rose
by 485.21 points that day, gaining back more than half of what it had lost the
day before because it appeared that a bailout package would be approved,
after all. The market turmoil caused by its earlier rejection convinced many
members of Congress that action was needed.
The SEC extended its short-selling ban on October 1, 2008, extending it to
three days after passage of the bailout bill. That evening, the Senate approved
the bill by a vote of 74 to 25. But the next day the Dow fell 348.22 points, as
uncertainty renewed over the bailout package. Members of the House then
realized that their inaction was undermining the markets and thereafter ap-
proved a new bailout bill by a wide margin. Formally titled the Emergency

Economic Stabilization Act of 2008, the bill was signed by President Bush
on October 3, 2008. By this point, the text had been lengthened considerably
from the original brief proposal.
The cost of passage of this act was the addition of provisions by various
members of Congress to benefit their constituents. Among other things, the
legislation contained $150 billion in tax cuts, including an extension of the
lifting of the ceiling for the alternative minimum tax. Acquiring banks were
allowed to take on the tax losses of failing banks. Banks were allowed to remit
cash from abroad without having to pay tax on those amounts. Community
banks that lost money on Fannie Mae and Freddie Mac stock were allowed to
treat those losses, for tax purposes, as ordinary losses rather than capital ones.
The bailout legislation even contained provisions for equalizing insurance
reimbursements for mental-health treatment.
Executive compensation critics reiterated their demand that limits be placed
on the amount of compensation paid to executives of any firm that received
government funds in the bailout program. This became a make-or-break is-
sue for the Democrats’ support for this proposal, and the Bush administration
caved in to that demand. The bailout package, therefore, contained a $500,000
limitation on executive pay for executives of corporations bailed out by the
federal government. Unlike the prior salary limitation of $1 million, the bailout
legislation had no exception for incentive-based pay. That raised the question
of how these financial institutions could hire a new senior executive officer.
It was unlikely that entrepreneurs would want to work for $500,000 per year,
when they could easily receive more lucrative positions elsewhere.
The legislation also prohibited golden parachutes for newly hired senior
executives at bailed-out firms, and corporations were authorized to “claw back”
(sue to recover) payments paid to existing officers based on a financial reports
that later proved to be wrong. The bailout legislation further sought to limit
executive compensation by prohibiting incentive payments for “unnecessary
and excessive risk.” The general consensus was that this would be very difficult
to enforce or to interpret, but that it was clearly directed at such executives as
O’Neal at Merrill Lynch. The irony of that effort was that Merrill Lynch had
implemented a bonus system in 2006 that sought to do exactly what Congress
now demanded by tying compensation to long-term performance. The Treasury
Department adopted rules that required financial services firms receiving bailouts
to have their CEOs certify that the company’s compensation committee had
reviewed its senior executives’ incentive compensation arrangements in order
to ensure that those programs did not encourage the taking of unnecessary and
excessive risks that could threaten the value of the financial institution.
Henry A. Waxman, a Democratic representative from California and,
since 2006, chairman of the House Committee on Oversight and Government
Reform, warned executives at financial firms receiving bailout money from
the federal government against using any government money for bonuses.
Senator Chris Dodd (D-CT) sought legislation that would claw back bonuses

from executives of bailed-out firms. In a reprise of Eliot Spitzer’s attack on

NYSE CEO Richard Grasso’s compensation package, Cuomo demanded that
nine large financial institutions receiving funds in the bailout provide him,
within one week, with a report detailing expected compensation and bonus
payments to their top management. He stated that payments in excess of the
value of the services provided by such executives might violate New York
state law. Cuomo issued a subpoena to the Bank of America after it was slow
in responding to this request.
Troubled Asset Relief Program (TARP)
The bailout relief provided in the Emergency Economic Stabilization Act of

2008 was called the Troubled Asset Relief Program (TARP). The legislation
created a reverse-auction system to purchase troubled assets from financial in-
stitutions. In such auctions, the Treasury Department would purchase securities
at the lowest prices offered by competing financial institutions. A thirty-five-
year-old assistant treasury secretary only six years out of business school but
already a former investment banker at Goldman Sachs, Neel T. Kashkari, was
placed in charge of this $700 billion program. The government also planned
to hire portfolio managers to manage the assets it purchased.
Inexplicably, even before the ink on the legislation was dry, the Treasury
Department decided to drop the asset-purchase program in favor of direct
injections of capital into faltering financial institutions. This radical change of
course caused confusion and criticism because the Treasury Department and
the Fed appeared to be flailing about for a solution and resorted to desperate
measures to save the economy without any real idea as to how to accomplish
that goal—which further undermined confidence in the market. Bailouts also
came to be viewed as a new entitlement. One money manager, Patriarch Part-
ners, took out a full-page advertisement in the New York Times on October 13,
2008, advocating the creation of a “Provisional Federal Bank” (PFB). This
PFB would make capital supplied by the Treasury Department available to all
“deserving” American companies, not just financial institutions.
More Problems
Retail sales contracted sharply in both September and October 2008, which
coincided with a rapid slowdown in consumer spending. Large upscale chain
stores reported sales declines of as much as 15.8 percent and a lower, but still
troubling, 3 percent at Target. The Fed announced that economic conditions
were weak across the country. However, this bleakness was not total: inflation
was declining, and crude oil prices fell to $87.81 on October 6, 2008.
The bailout package failed to restore confidence in the market. The Dow
Jones Industrial Average fell below 10000 on October 6, 2008, losing 369.88
points—the first close below 10000 in four years. European stocks experienced

their greatest loss in twenty years. The Volatility Index, a popular measure of
stock market volatility, surpassed 50 on this day, for the first time since the
stock market crash of 1987. During the week of October 6, 2008, the Dow
Jones Industrial Average had its worst losses ever in terms of both points and
percentage points, and a global sell-off of securities began.
The Fed tried to rescue the commercial credit market on October 7, 2008,
by creating and funding a backup facility, a special-purpose entity, to purchase
commercial paper directly from eligible issuers at a spread over the three-
month overnight swap index rate. This was the first direct lending by the Fed
to commercial corporations since the Great Depression. But it was not the first
time that the Fed had to deal with a crisis in the commercial paper market.
The bankruptcy of the Penn Central railroad in 1971 caught commercial paper
investors by surprise because that company’s paper had been highly rated.
Investors holding Penn Central commercial paper suffered large losses, and
other investors in the commercial paper market began panicked redemptions,
which the Fed had to dampen by opening its window to allow $1.7 billion in
borrowings in Fed funds during a single week in July 1970.
Stock markets around the world were in freefall. On October 7, 2008, the Dow
fell by 508 points. That fall brought the decline in the Dow to more than 1,400
points in just five days of trading. Markets were down 18 percent for the week in
the United States, 21 percent in London and Frankfurt, and 24 percent in Tokyo.
The stock market fell again on October 8, 2008, for the sixth consecutive day.
Government Reactions
The Fed coordinated a historic global rate cut that day, reducing rates by a
full half a percentage point. The European Central Bank (ECB) and the Bank
of England followed suit. Before October 2008, the ECB had not cut interest
rates for five years, but a disparity remained in the rates of those central banks.
The Bank of England’s new rate was 4.5 percent, the ECB’s was 3.75 percent,
and the Fed rate was only 1.5 percent. Questions were raised as to how such
rate-setting policies could exist in a global economy where money could be
easily moved to take advantage of such differing rates.
At the same time, the SEC reversed its short-sale prohibition amid criticism
of its effectiveness and the confusion that it added to the market. An economic
study subsequently determined that declines in the stock prices of financial
firms covered by the SEC’s emergency order could not be attributed to short
selling. The study further found that the SEC short-selling restrictions had
resulted in a decline in the quality of the market for the affected stocks. SEC
chairman Christopher Cox later asserted that he regretted the imposition of
the ban on short selling and that it had been adopted only under pressure from
Treasury Secretary Paulson and Fed chairman Bernanke.
The SEC appeared impotent during the subprime crisis, and Cox’s complaint
about Paulson and Bernanke further undermined the agency’s credibility. His

comments raised questions as to the SEC’s independence and weakness, and

traders in the marketplace, who claimed that those restrictions had only further
destabilized the market, questioned the agency’s competency.20 Whatever their
effectiveness, bans on short sales were adopted by governments around the
world. The Financial Services Authority in London announced on October 22,
2008, that it would continue its ban on short selling. Criticism of short-sellers
continued. Citigroup blamed the continuing attacks on its stock (which drove
it below a dollar at one point) on short-sellers and urged the SEC to restore
the uptick rule for short sales.
Market Volatility
The U.S. market plunged sharply in the last hour of trading on October 9, 2008.
The Dow dropped to 8641.95, closing below 9000 for the first time since 2003.
That happened just after the SEC’s ban on short selling was lifted for financial
stocks. The Dow had fallen about 35 percent from its record high on October
9, 2007. Crude oil prices and other commodity prices also fell. Commodity-
based mutual funds had lost, on average, over 26 percent of their value since
July, whereas in 2007 they had gained over 23 percent.
The next day, crude oil prices fell to $77.70, as world leaders agreed to work
together to stabilize the financial situation. However, they had no agreed-upon
proposals for doing so, other than the coordination of their interest rate cuts and
an agreement to keep one another informed of actions that they might take in their
own country. The Dow continued its downward plunge for the seventh straight
day. The market gyrated wildly, swinging 1,019 points during the trading day,
making it the most volatile session ever. By the time the day ended, the Dow had
dipped 128 points, closing at 8451.19, its lowest level since April 25, 2003. A
crash is usually defined by a decline in stock values of 20 percent or more over
a short period of time. During this particular week, that average fell by more
than 20 percent, and shareholders lost some $8.4 trillion in value.
Financial analysts predicted that the United States was in a “secular” bear
market, in other words, the market would not recover for a long time. The
Dow was then more than 40 percent lower than its record high the preceding
October, in its sharpest decline since 1974. The corporate bond market and
investment grade bonds declined in value, the latter by 11 percent since the
beginning of September, while junk bond values fell by 17 percent. Asian and
European markets also plunged. The Nikkei Average had its worst trading day
in more than twenty years.
The TARP Bailouts
On October 13, 2008, the Bush administration announced the investment of

$250 billion in several of the largest banks using TARP funds, including Citi-
group, Bank of America, Wells Fargo, and JPMorgan Chase, each of which

would receive $25 billion. Citigroup and Bank of America were later given
additional amounts. Goldman Sachs and Morgan Stanley were given $10 bil-
lion each. Bank of New York Mellon received a lower amount. The big banks
were pressured to take the assistance, even if they did not need it, in order to
make it appear that it was not just a rescue for failing institutions.
This policy reflected the experience of the Reconstruction Finance Corpo-
ration (RFC) during the Great Depression. The RFC discovered that banks
were reluctant to take government funds because of the stigma that would
attach—they were afraid that the public would think that they were failing.
Publication of RFC loans had been required by Congress after the RFC made
$90 million in loans to the Central Republic Bank and Trust in Chicago, which
was managed by Charles G. Dawes, the former head of the RFC and President
Herbert Hoover’s first vice president. The RFC became something of a model
for the Bush administration during the bailout. The RFC itself was fashioned
after the War Finance Corporation, created in 1918 to make loans to private
industry in order to support the war effort. By 1935, the RFC had purchased
$1.3 billion in preferred stock from more than 6,500 banks and held preferred
stock in over half of all U.S. banks. It lent about $1 billion to 4,000 borrowers,
which included many mortgage lenders and railroad companies.
One of the RFC’s earliest loans was for $15 million to save Bank of America,
which then, as now, had one of the largest banking operations in the country.
So, it was ironic that Bank of America would have to be rescued again under
the TARP program, but this time the investment was $45 billion, on which the
government received annual dividends of $2.8 billion.
The RFC also discovered that banks to which it had disbursed funds re-
fused to lend them. Rather, they were kept as bank reserves and held in U.S.
government securities. As Jesse Jones, an RFC board member, stated: “There
has been too much reluctance on the part of banks, trust companies, etc., to
borrow for the purpose of relending. . . . Most banks have been endeavoring
to get as liquid as possible . . . too much for the public good.”21 The Treasury
Department encountered similar problems with TARP funds.
Lending by the RFC failed to forestall the collapse in the banking system
in 1932. Out of the seventy-nine banks receiving RFC loans 56 percent failed.
However, an RFC program enacted under emergency banking legislation in
1933, which allowed the RFC to purchase preferred stocks of distressed banks,
was more successful. Only 12.5 percent of the eighty banks selling preferred
stock to the RFC failed. The preferred stock program was resisted at first, but
the RFC sweetened the deal by reducing the preferred dividend rate from 6
to 4 percent. The RFC also urged the largest and most prestigious banks to
participate in the program in order to encourage participation by smaller banks.
The popularity of the program grew after the National City Bank of New York,
now Citigroup, sold $50 million in preferred stock to the RFC.
The Treasury Department borrowed this page from the RFC playbook and
used preferred stock programs to boost bank capital with TARP funds. The

initial $250 billion in TARP investments was made in the form of preferred
stock purchases that could be treated as a Tier 1 capital. The banks would pay
the government a special preferred dividend of 5 percent in the first five years
and 9 percent thereafter. In addition, the government received warrants valued
at 15 percent of the face value of the preferred stock. This allowed the govern-
ment to purchase stock in the banks if it rose in price, allowing taxpayers to
share in the increased value of the common stock.
The government had voting rights only with regard to matters affecting
its preferred stock, but could appoint directors if its dividends were missed
for six quarters. The government could sell the preferred stock if it desired,
and the banks were allowed to redeem the preferred stock after three years at
face value. The Treasury Department said that it would not require banks to
eliminate dividends on their common stock, but that the government would
have to approve dividend increases.
The Bush administration announced in October 2008 that it would guarantee
all senior debt issued by large financial institutions over the next three years.
The FDIC also guaranteed bank deposits on non-interest-bearing accounts,
which were mostly business accounts, and Congress increased its deposit in-
surance for retail depositors to $250,000 per account. The Fed then announced
that it was providing an unlimited amount of dollars to central banks of three
European countries that were running short.
These announcements caused the stock market to soar. The Dow rose by
936.42 points on October 14, 2008, an 11 percent gain, the largest one-day
gain ever, to close at 9387.61 The S&P 500 rose by 11.6 percent, its best day
since 1939. Markets around the world also rallied strongly. The stock market
rally came too late for Sumner Redstone, who controlled Viacom and CBS.
He was forced to sell a large portion of his stock in those corporations after
he received a margin call on a $1.6 billion loan that he had used to invest in a
movie theater chain. In the meantime, commodity prices declined. Oil prices
fell by more than 44 percent in recent months, and cereal grains were down
by almost as much. However, the federal deficit continued to grow, reaching
$455 billion in October 2008.
That month, the Federal Reserve Bank of New York called a meeting of
large investment bankers who were parties to more than 90 percent of credit
derivatives and urged them to make the market more transparent. At that time,
the notional amount of outstanding credit derivatives was $62 trillion. One
commentator in the Wall Street Journal advocated that bank executives be
required to undergo a periodic grilling by a panel of regulators on the risks
incurred in their businesses and the steps they were taking to manage those
risks.22 The failure to correctly consider risks associated with subprime mort-
gages had, indeed, changed the financial landscape.
The merger of Merrill Lynch and Bank of America left only two large indepen-
dent investment banking firms in the United States, Goldman Sachs and Morgan
Stanley. However, that was only a temporary condition as Morgan Stanley and

Goldman Sachs converted to bank holding company status on September 22,

2008. This conversion appeared to have further marginalized the SEC, making
the banking regulators the prime regulator for those investment banks and turned
back the clock to the 1920s. Goldman Sachs seemed to have weathered the storm
better than others. It had comparatively little subprime exposure, but was caught
up in the maelstrom that ripped into the financial markets after Lehman Brothers
failed. To restore faith in the firm, Warren Buffett announced on September 23,
2008, that he was investing $5 billion in Goldman Sachs. Goldman was also able
to complete a $5 billion stock offering right after that announcement.
Municipal Securities
In October 2008, the municipal bond market suffered as well after concern
was raised over those securities because of the downgrading of credit ratings
for MIBA and Ambac Financial Group, which lost their triple-A ratings. Those
firms had been large guarantors of municipal securities, but their entry into the
CDO insurance business had crippled them financially, undercutting the value of
their municipal guarantee. Berkshire Hathaway Assurance Corporation, which
did have a triple-A rating, entered the market after MIBA and Ambac began to
experience difficulties. It was hoped that the market could be boosted by a new
bond insurer, Municipal and Infrastructure Assurance Corporation (MIAC),
which was backed by the Macquarie Group and sought a triple-A rating.
The Municipal Securities Rulemaking Board (MSRB) proposed a new
centralized information system for municipal securities as a way to dampen
the extreme volatility in that market. The MSRB was in discussions with the
Treasury Department, seeking a bailout for states with difficulty raising funds
in the frozen municipal bond market. Several states faced budget crises as a
result of a downturn in their revenue and inability to tap the capital markets
for funds. They were also blocked from any federal guarantees because of tax
laws barring any such guarantees for tax-exempt bonds.
California appeared to have solved its problems in September 2008 by
closing a $15 billion deficit in the state budget. However, in November 2008
the state evidently was going to incur an additional $1.1 billion deficit. There
was some concern that a federal government bailout would be needed to sup-
ply cash to that state. CalPERS announced on October 22, 2008, that it would
demand additional funds from public employers if its portfolio assets contin-
ued to decline. It disclosed that it had experienced losses of 103 percent on
its residential real estate investments for the fiscal year ending June 30, 2008,
because borrowed funds had been used to leverage those properties.
General Electric
General Electric (GE) issued a profit warning on September 25, 2008, the
second such warning that year. The company announced the implementation

of programs to conserve cash and reduce debt. It also cut back its financial
services operations and raised $12 billion in new capital from public offer-
ings, plus $3 billion from Warren Buffett. GE’s CEO, Jeffrey Immelt, had
earlier advised financial analysts that he expected third-quarter results would
be highly favorable. In the wake of that “shocking” news, the Dow fell to
12325.42. Former CEO Jack Welch was critical of Immelt for making claims
of profitability that he could not deliver.
GE was generally viewed as an industrial company, making everything from
washing machines to jet engines. However, GE had been converting itself into
a financial services firm for some time, becoming the largest nonbank finance
company in the United States with financial operations larger than that of all but
four commercial banks in the United States. During the subprime crisis GE was
pummeled by concerns over its financial services operations. The company’s
stock was also volatile as a result of the convulsions in the financial markets.
Troubles at GE caused Citigroup to shut off its debtor in possession financing,
which involved making loans to companies that declared bankruptcy so that
they would have some working capital during the reorganization or windup.
This had been a $1.75 billion business, and its pullback was raising concern
that companies would no longer be able to afford to declare bankruptcy.

13. The Crisis Continues
The Contagion Spreads
Crisis Abroad
After the market crashed in the United States, falling 24.7 percent during the week
of October 6, the contagion spread abroad. This confirmed the fact that financial
markets were global and interconnected. Stock markets worldwide felt its effects,
with declines in succeeding days of 36.7 percent in Japan; 19.8 percent in Australia;
24.4 percent in India; 30.4 percent in China; and 61.4 percent in Russia. Closer
to home, the markets fell by 34 percent in Canada; 28.6 percent in Mexico; and
40.9 percent in Brazil. In Europe, markets dipped 27.9 percent in Germany; 27.3
percent in the UK; 24.9 percent in France; and 23.4 percent in Spain.
European governments announced on October 13, 2008, that they would
provide massive funding to support their banks. On October 19, 2008, the
Dutch government announced a $13 billion rescue package to ING Group, a
banking and insurance company. However, ING recouped some of its losses
when the stock market jumped the next day. Credit Suisse announced that it
would pay its executives bonuses with illiquid securities, which was one way
to get rid of those instruments and turned out to be a good scheme when the
market recovered.
Mortgage approvals in the UK were at a record low, and consumer borrowing
was down in the third quarter of 2008. The British economy contracted for the
first time in sixteen years in that quarter. The Bank of England estimated that
about 10 percent of mortgage holders in the country had mortgages that exceeded
the value of their homes. The government injected $87 billion into Barclays,
Lloyds, the Royal Bank of Scotland, and other banks on October 7, 2008.
The following day the British government announced a £400 billion pro-
gram to prop up its financial institutions and pressured banks to make loans
to consumers, but the banks resisted. Banks in the UK also protested charges
imposed by the government for its bailout capital injections, which could
reduce their earnings by as much as 15 percent. The rescued banks were also
prohibited from paying shareholder dividends until the loans were repaid.
572

The Crisis Continues 573
The British government began the process of nationalizing the Royal

Bank of Scotland Group and HBOS (a subsidiary of Lloyds). Barclays Bank
refused an equity injection from the government because of its onerous terms
and also refused to participate in a government-sponsored bank asset insur-
ance program rolled out in March 2009. Barclays obtained $10.4 billion in
capital in Abu Dhabi and Qatar in October 2008 to boost its capital and cut
3,000 jobs.
Ireland announced on September 30, 2008, that it would guarantee the
obligations of its major banks up to $563 billion, with no limits on deposit
insurance. The Irish economy was soon in a tailspin, and the government
created the National Asset Management Agency (NAMA) to act as a “bad”
bank for the purchase of distressed commercial property loans from five of
the six largest banks in the country. Those purchases were expected to total
$123 billion.
Elsewhere in Europe, governments bailed out banks in danger of failing,
including Fortis, which was rescued by the governments of Belgium, the
Netherlands, and Luxembourg with their injection of $16.37 billion. Fortis
announced a $411 million loss on December 24, 2008, as a result of currency
transactions made in preparation for the acquisition of some of its assets by
BNP Paribas. That acquisition was already in trouble. The Belgian govern-
ment offered to resign in December 2008 after it was revealed that cabinet
ministers had tried to pressure a judge to approve the sale of the banking and
insurance assets of Fortis to BNP Paribas. A court in Belgium had ruled that
minority shareholders should have been allowed to vote on that sale. That vote
was held in February 2009, and the shareholders rejected the merger, sending
the fight back to the courts.
The French-Belgian bank Dexia received a $9 billion rescue package on
September 30, 2008, from the Belgian, French, and Luxembourg governments.
Otherwise, the Europeans could not agree on a collective bank rescue program.
The French proposed a Europe-wide rescue fund of over $400 billion, but Great
Britain preferred to handle problem financial institutions on a case-by-case
basis. France created a $33 billion stimulus package for its lagging economy,
and on October 20, 2008, its government announced an injection of nearly
$20 billion into six of its largest banks. Banque Paribas, Deutsche Bank, and
Natixis each lost several hundred million dollars in their trading operations
in October 2008. Caisse d’Epargne, a French bank, lost almost $900 million
trading equity derivatives that month.
Hypo Real Estate Holdings in Germany, in which the Flowers private eq-
uity firm had invested $1.7 billion, was about to fail. However, the German
government came to the rescue with a $142 billion package. Germany also
guaranteed all consumer bank deposits and pushed through a $750 billion
rescue package for its financial institutions as well as approved a $39.6 bil-
lion economic stimulus package on December 5, 2008. Finance Minister Peer
Steinbrück blamed the global credit crunch on “snooty” bankers.

Zurich Financial disclosed on October 2, 2008, that it would take a $650

million charge as a result of the failure of Lehman Brothers, Washington
Mutual, and Sigma Finance Corporation. The Swiss government reported
on October 16, 2008, that it would spend $60 billion to purchase distressed
assets held by UBS, which had suffered massive losses from subprime mort-
gages bought in the United States. In return, the Swiss government received
convertible notes that would pay a fixed interest rate but could be converted
into equity later. It also invested $5.3 billion in UBS in exchange for an equity
stake of 9 percent.
Some European banks resisted capital infusions from their governments
because of the limitations on compensation and business activities that were
attached as conditions for those equity investments. Instead, it appeared that
the European banks borrowed from U.S. banks, which was not a bad thing
because it was the first signal of a thaw in the credit markets. One Spanish
bank, Banco Santander, even sought an investment opportunity by trying to
take over Sovereign Bancorp, a large U.S. thrift holding company, during the
week of October 6.
Economies throughout Europe were in decline in 2008. Spain reported the
slowing of its economy and an increase in unemployment. Most European
countries were declared to be officially in a recession on November 14, 2008,
after experiencing economic declines for two straight quarters. The National
Bank of Hungary, Hungary’s central bank, raised interest rates by 300 basis
points on October 22, 2008, in order to prevent a run on its currency. Currency
concerns in Denmark caused its government to seek another referendum on
whether it should adopt the euro as its currency. The European Central Bank
(ECB) extended an emergency loan to the National Bank of Hungary as the
financial crisis spread to that country. On November 6, 2008, three central
banks cut their interest rates: the Bank of England by 1.5 percent and the ECB
and the Swiss National Bank by 0.50 percent. Europe was also easing mark-
to-market requirements for banks.
Iceland was especially hard-hit by the subprime crisis. Until that time it
had been on a worldwide financial services binge and was prospering. But
when the financial crisis came to Iceland, all three of its major banks failed.
The government injected $827 million into Glitnir Bank. But, fearing that the
government could not afford to bail out its other troubled banks Iceland’s stock
markets went into a freefall. This was no idle fear, as Iceland’s government
indicated that it was at risk of bankruptcy on October 5, 2008. The Central
Bank of Iceland raised interest rates on October 20, 2008, by 18 percent to
support the Icelandic krona. Seeking assistance, Iceland, on October 24, 2008,
approached the International Monetary Fund (IMF) for a loan of $2 billion.
It was slow to close the deal, but on November 16, 2008, after Iceland agreed
to cover deposits of Europeans, as well as its own citizens, in Iceland’s failed
banks, the IMF authorized the extension of $8 billion. By then, the country’s
banks were nationalized, and the entire banking system had collapsed, soon

to be followed by the government itself on January 26, 2009. Relying on an

anti-terrorism statute, the UK seized Iceland’s assets in London as security for
deposits made by British citizens in Icelandic banks. The Althing, Iceland’s
legislature, later passed a law offering a government guarantee to repay de-
positors from the UK and Netherlands $5 billion that they lost in online ac-
counts with “Icesave,” run by Landsbanki, one of the failed banks. Although
the prime minister and foreign minister supported the legislation, Iceland’s
president, Olafur Grimsson, vetoed it, and Iceland voters upheld that action
in a national referendum. Iceland also injected $2.1 billion into its banks in
July 2009 and announced plans to turn over control of two of the country’s
largest banks to foreign creditors.
Despite the Russian government’s effort to bolster it, the ruble was falter-
ing as oil prices declined. The government provided $50 billion in loans to
help its large corporations repay foreign debts. The value of shares on Russian
exchanges fell by 20 percent on September 16, 2008, during the height of the
Lehman Brothers debacle. Russian markets were closed for two days as the
value of bank stocks tumbled. To help rescue the banks, the government offered
a $120 billion package. However, Russia’s credit rating was downgraded in
December 2008 because of the depletion of its reserves. The ruble was devalued
twice in one week in mid-December and six times in seven days in January.
In Hong Kong, on September 24, 2008, nervous depositors began a run
on banks, specifically the Bank of East Asia, where long lines were seen at
several branches. Japan announced a stimulus package totaling $51 billion
on October 30, 2008, but the country’s industrial output experienced a record
decline the next month anyway. The government also proposed consolidating
Japan’s financial markets for stocks and commodities under a single holding
company that would be owned by the existing securities and commodities
exchanges. This consolidation would not be completed until 2013.
The financial group Mitsubishi UFJ reported on October 27, 2008, that it
would raise $10.5 billion in capital to bolster its balance sheet in light of rising
market turmoil. Meanwhile, the exchange rate of the yen was rising rapidly
against major foreign currencies, causing concern worldwide. It was thought
that this was due to “carry” trades, in which investors had obtained Japanese
funds at low interest rates and invested them in risky securities abroad to earn
a tidy profit on the spread.
South Korea also experienced financial difficulties. The Bank of Korea, its
central bank, pumped $5 billion into financial markets in October 2008. The
value of its currency, the won, fell by 30 percent against the dollar in October.
On October 19, 2008, South Korea cut its interest rates and announced a $130
billion rescue program for its banks, which included a $100 billion guarantee
for foreign currency loans and an injection of $30 billion into the Korean bank-
ing system. However, South Korea declared that it would not seek aid from
the IMF because such funding is conditional and the country had an earlier
history with public reaction to such an agreement. During the 1997 financial

crisis in Asia, called the “Asian Flu,” riots broke out due to public sentiment
that IMF loan conditions impinged on Korea’s sovereignty.
In China, runaway growth in the economy was met with a slowdown in the
fourth quarter of 2009 as worldwide demand slackened during the crisis. The
Chinese legislature adopted a $586 billion stimulus package on November 9,
2008, to aid its declining economy, which began recovering in 2009. Abroad
it sought to increase its power and prestige by pushing for a greater role for
the IMF and for China’s participation in it. China also proposed the creation
of a new currency to be administered by the IMF as the international reserve
currency, in place of the U.S. dollar. U.S. Treasury Secretary Tim Geithner
casually remarked in an interview that he would be open to consideration
of such a proposal, which caused some nervousness in currency markets, as
shown by a sharp drop in the dollar on March 25, 2009.
For his part, the prime minister of China, Wen Jiabao, reacting to economic
conditions in the United States, went on the offensive with his concern that
the crisis might endanger the massive amount of Chinese funds invested in
U.S. securities. He demanded assurances from the United States that it would
guarantee the $1 trillion in U.S. debt held by China, assurances that were
unnecessary. Wen had earlier criticized the United States as a country of
unsustainable development marked by low savings and high consumption—
consumption, that is, of goods manufactured in his country.
Taiwan’s economy was in recession as the global financial crisis spread to
its shores. The government cut interest rates in an effort to boost its economy,
and it did pick up in 2009. To help South Korea, Singapore, Mexico, and Brazil
weather the storm, the U.S. Federal Reserve (the Fed) disclosed on October
29, 2008, that it would lend $30 billion to banks in those countries. Australia
agreed to guarantee debt offered by its largest banks. As the dollar’s exchange
rate rose rapidly against other currencies in October 2008, Mexico and Brazil
spent billions of dollars to support their currencies.
Governments around the world were implementing rescue programs for their
banks including Australia, Taiwan, Portugal, and the United Arab Emirates
(UAE), in October 2008. The Central Bank of Kuwait stopped trading in the
stock of the Gulf Bank, one of the country’s largest banks, after a customer
defaulted on a derivatives transaction that was rumored to have caused losses
of $750 million. On October 26, 2008, Kuwait’s central bank stepped in to
guarantee bank deposits and arrange for the bailout of the Gulf Bank. In re-
sponding to investors who lost money and mounted suit against the country’s
stock market, a Kuwaiti court ordered the stock exchange in Kuwait City to
be closed on November 13, 2008. The Kuwait Investment Authority helped
shore up the Kuwaiti stock market by announcing plans to buy large amounts
of the stock traded there.
Saudi Arabia made available some $2.3 billion in loans to low-income in-
dividuals and provided $40 billion in lending facilities to its banks. The UAE
guaranteed domestic bank accounts for three years and announced the creation

of an interbank lending facility. The Dubai real estate market was also soften-
ing. In November 2008 the IMF granted Pakistan a $7.6 billion loan.
The IMF resumed its role as 911 emergency liquidity provider elsewhere. It
prepared to establish monetary facilities to rescue the economies of countries
around the world as the financial crisis spread. The IMF agreed in October 2008
to supply funds to Ukraine in order to rescue its faltering economy. However,
that program was stalled by Ukrainian unwillingness to submit to IMF loan
conditions. The cost of refusal was considerable, as Ukraine’s banking system
was collapsing and nine banks were subsequently taken over by the govern-
ment. Later, in 2009, the IMF announced the creation of a $100 billion facility
for making nonconditional loans to troubled economies. That loan facility was
designed to attract Mexico, Brazil, and South Korea, which had previously
resented the conditional loans given to them by the IMF in prior crises.
The IMF had appeared to be a dead letter as the twenty-first century began,
but it reemerged as a powerhouse during the subprime crisis. The IMF effec-
tively acted as staff for the Group of Twenty and sought to serve as a global
central bank. Geithner wanted to have the Group of Twenty, at their meeting
in London in April 2009, approve additional funding for the IMF, which it did,
making a $1 trillion commitment to the IMF, quadruple its existing resources.
Later, the IMF and the World Bank declared that the Group of Seven had
become irrelevant and that the World Bank and IMF should play a leading
role with the Group of Twenty. The World Bank pledged $100 billion in new
lending to middle-income countries, but received resistance from its owner
countries for the addition of new capital to support such lending.
Private Equity
The private equity market was hit hard by the subprime crisis. Private equity
firms weighed down their acquisitions with $741 billion of debt between
2005 through 2008. That leverage caused problems for those businesses as
the subprime crisis deepened. In the first eleven months of 2008, 109 large
companies filed for bankruptcy, of which sixty-seven involved private equity
investments. The amount of transactions in the private equity business fell
about 70 percent during 2008. Acquisitions in the fourth quarter totaled only
$6 billion, compared to $110 billion in the second quarter of 2007, just before
the credit crunch. The credit crunch slowed private equity investments because
of their inability to access large capital sources and because the banks had
shut down lending.
By the second quarter of 2008, the contagion had spread to the leveraged
loan market, where defaults increased, reaching a five-year high in August.
Standard & Poor’s estimated that leveraged loans held by banks were worth
only about sixty-six cents on the dollar at year-end 2008. The average size of
buyout deals fell to $78.8 million in the fourth quarter of 2008, down from
$280.8 million for the same period of 2007 and $726 million in 2006.

Kohlberg Kravis Roberts (KKR) had a $1.2 billion loss in 2008. Its pur-
chase of Dollar General turned out to be prescient during the subprime crisis
as consumers turned to lower-end stores and was one of the few private equity
purchases that did not suffer during the subprime crisis. For example, the KKR
investment in First Data investment was written down by 45 percent from its
purchase price of $29 billion. A TXU investment of $37 billion was written
down by $8.9 billion by KKR.
Private equity was hurt by the subprime crisis but also saw opportunity.
Henry Kravis from KKR warned at an economic summit conference in Da-
vos, Switzerland, that private equity groups were exploring ways to bypass
the banks, which had stopped lending. Banks serve as intermediaries between
depositors who are, in effect, making a loan to the bank, and borrowers that
borrow the depositors’ funds. Private equity sought to bypass that intermedi-
ary role by going directly to institutions that provide capital such as insurance
companies, pension funds, mutual funds, and sovereign wealth funds.
Raising funds became increasingly difficult during the subprime crisis. In-
deed, many investors tried to withdraw their investments. Some private equity
groups created “annex funds” that sought additional funds from investors, but
they received a cold reception. Apollo Management dropped plans to create an
annex fund after some of its largest investors protested. Nevertheless, there did
seem to be a little bit of juice left in the private equity sector. Nordic Capital,
a private equity fund, was able to raise $5.3 billion in November 2008. In
October 2008, another European private equity group, Bridgepoint Capital,
raised over $6 billion.
A planned merger between Huntsman and Hexion Specialty Chemicals,
owned by the private equity group Apollo, was in danger as October ended
because Credit Suisse and Deutsche Bank, the banks that agreed to fund the
deal, backed out of their commitments.
Apollo Global Management—Apollo’s Amsterdam-listed hedge fund—
announced a 45 percent decline in the value of its assets in the fourth quarter
of 2008. An Apollo feeder fund also listed in Amsterdam, Apollo Alternative
Assets, lost $700 million in net asset value in the fourth quarter of 2008.
Cerberus Capital Management converted to a bank holding structure in
October 2008 in order to be eligible for funds from the Troubled Asset Relief
Program (TARP). Cerberus had its first negative year in 2008, after sixteen years
of profits, and it suspended redemptions. However, investors demanded the return
of $5.5 billion of their funds, about 20 percent of the assets under management.
The firm agreed to begin liquidations to return those funds but also announced
a three-year lockup of funds held in two of its new hedge funds.
Permira, a large private equity group based in London, announced in Decem-
ber 2008 that it would allow its investors to withdraw as much as 40 percent
of their equity commitments in its $14 billion buyout fund. However, they
would have to continue to pay management fees on the original commitments
and forgo some future profits.

Some private equity groups rode out the storm by sitting on vast hoards of
cash. As December 2008 began, TPG held $30 billion, Bain Capital $20 bil-
lion, and the Carlyle Group and Apollo Management $14 billion each. Other
private equity investors tried to profit from the subprime crisis late in 2008 by
taking advantage of companies with distressed debt. Having been acquired in
2006 by the private equity group Sun Capital Partners, with the assistance of
financing provided by Fallon and KKR, Real Mex Restaurants was taken over
in December by Fallon Capital Management and KKR, and its top managers
were replaced. After Real Mex began having difficulty meeting its financing
commitments, Fallon and KKR took control and reduced the prior owners’
ownership stake to 15 percent. In other instances, private equity groups were
buying distressed debt and using their leverage as creditors to take control.1
Union pension funds had second thoughts about their strategy of investing
in alternate asset categories with hedge funds and private equity groups. The
average public pension plan held about 5 percent of its assets in private equity
and hedge funds in 2008. The California State Teachers Retirement System
had about 14 percent of its assets in private equity. That pension fund and the
California Public Employees Retirement System (CalPERS) experienced large
losses from those investments and found themselves subject to capital calls from
private equity groups, which required them to sell other assets at a loss.
Hedge Funds
The subprime crisis had a significant effect on hedge funds. Hedge funds
holding mortgage-backed securities experienced large losses in the beginning
of 2007. Indeed, the subprime crisis actually seems to have started in June
2007 with the failure of two Bear Stearns hedge funds that were investing
in subprime loans purchased at a cost of some $4 billion. Hedge funds also
encountered a credit crunch in mid-2007 as banks, once virtual money spigots
for hedge funds, curbed lending. Among the casualties were investors in the
Raptor hedge fund managed by Tudor Investments, who redeemed $1 billion
of their investments, after it sustained losses in 2007. Nevertheless, several
hedge funds saw large gains in 2007, despite concerns in the credit markets.
Hedge funds experienced an overall average gain of 12 percent for the year.
Nearly fifty hedge funds, holding a total of $18.6 billion in assets, closed in
2007. However, those numbers were lower than 2006, when more than eighty
hedge funds, managing a total of $35 billion, closed.
In August 2007, the Carlyle Group made $200 million in loans to its mort-
gage-backed fund, which was listed on the Euronext Amsterdam exchange.
The fund was in trouble as the subprime crisis mounted, and it was forced to
sell off $900 million in assets to cover margin calls. The share prices of the
fund fell from $19 to $1. A Carlyle Group hedge fund holding $22 billion in
mortgages collapsed on March 13, 2008, as a result of declines in the value
of its mortgage investments. The Carlyle Capital hedge fund was heavily

leveraged, with a ratio of debt to equity of about 32:1. It faced a liquidity

problem, as margin and collateral calls increased with the market’s decline.
The fund’s managers asked for a moratorium on further forced distress sales
of its assets on March 10, 2008. By then, that hedge fund had liquidated $5
billion of its $21 billion portfolio. The banks refused that request. The Carlyle
Group hedge fund stated that its investment risk management model had been
based on the worst-case scenarios that resulted from the Long Term Capital
Management (LTCM) crisis in 1998, but that model was overwhelmed by the
subprime market crisis.
Speaking of LTCM, John Meriwether, who headed LTCM in 1998, when it
lost $4 billion and had to be bailed out through an investment banking rescue
organized by the Federal Reserve Bank of New York, was in trouble again
in March 2008. JWM Partners, a hedge fund opened by Meriwether after the
LTCM debacle, had been able to take advantage of a stock market downturn
in February 2007. However, that turned out to be an aberration. JWM Partners
lost 28 percent in value in the first three months of 2008. Meriwether laid off
employees as 2008 ended and returned investor funds in March 2009.
Another money manager, Drake Capital, halted redemptions in its $2.7
billion hedge fund on March 12, 2008. The amount of assets held in hedge
funds declined by 2.9 percent in the first three months of 2008, which was one
of their worst quarters in hedge fund history. Because banks restricted their
credit lines, some hedge funds had to liquidate securities to meet cash needs
and redemption requests. This put further pressure on the market, which was
already under severe stress. Losses soon piled up. The hedge fund Richmond
Capital lost about half its net asset value in January 2008. Peloton, a once
high-flying hedge fund that had reported a gain of 87 percent in 2007, was
liquidated in February 2008 because of large losses from asset-backed securi-
ties. Focus Capital, once a billion-dollar hedge fund, was forced to liquidate
in March 2008, after it could not meet margin calls from its banks.
United Capital, a Miami-based hedge fund operator, stopped redemptions in
July 2007 and failed entirely a year later, with losses exceeding $600 million
from asset-backed securities. Its thirty-eight-year-old CEO, John Devaney,
was living large before those funds crashed. Among other things, he owned
an $11 million helicopter, a 141-foot yacht, and a $38 million home in Key
Biscayne that had been featured in the movie Scarface.
A Fortress Investment Group hedge fund holding mortgage-backed securi-
ties declined by 30 percent in July 2008. The hedge fund bought over $500
million in triple-A-rated mortgage-backed securities in the spring of that year,
on the theory that the subprime crisis had bottomed out and the securities
were undervalued as a result of the panic during the crisis. Endeavor Capital,
a London hedge fund, lost some $750 million of its $3 billion in assets as a
result of a position involving a spread between short- and long-term Japanese
government bonds (JGBs). Several other hedge funds also incurred huge losses
in such transactions.

Atticus Capital, a New York–based hedge fund, lost more than $3 billion
in the first three quarters of 2008. Elgin Capital, a hedge fund investing in
credit-related instruments, announced the suspension of redemptions because
of losses in the leveraged-loan and high-yield bond markets. Bain Capital
Credit, a private equity group, had troubles with two of its hedge funds that had
invested in highly secure corporate loans, which lost 50 percent of their value
by October 22, 2008. A $58 million hedge fund sued Citigroup and Wachovia
for requiring it to pay its obligations on credit-default swaps (CDSs) because
it turned out that they were riskier than the hedge fund had thought.
Some hedge funds were able to profit from the subprime crisis. James H.
Simons and George Soros separately made $3 billion. The top twenty-five
hedge fund managers were rewarded with more than $360 million in 2007 as
fees and bonuses. The top fifty hedge fund managers made a total of almost
$30 billion. The hedge fund Magnetar Capital, named after a neutron star by
its founder, Alec Litowitz, an astronomy buff and a former trader at Citadel
Investment Group, was deeply involved in collateralized debt obligations
(CDOs) totaling $30 billion. Such investments turned toxic during the subprime
crisis. However, that hedge fund was able to profit because it had hedged itself
against the risk of its investment in those obligations through CDSs and made
other profitable investments. The Citadel Investment Group did not fare as
well as its former trader. In December 2008, it closed its office in Japan and
sharply reduced operations in Hong Kong as those markets dried up.
By betting against the subprime market in 2007, John Paulson, another
hedge fund manager, made some $15 billion, of which he received $3 billion.
He hired Alan Greenspan, the former chairman of the Fed, as an adviser—
an event viewed with some irony in the press because Greenspan was being
blamed for fueling the housing boom during the last years of his tenure at the
Fed by keeping interest rates low and then breaking the market with a series
of interest rate increases. A friend of Paulson, Jeff Green, made $500 million
by betting against the housing market, after taking the idea from Paulson. The
gains made by Paulson came at the expense of other traders, and as described
in Chapter 7 some of Paulson’s trades were the center of a sensational suit
by the Securities and Exchange Commission (SEC) against Goldman Sachs,
which had arranged a CDO between Paulson and a German bank.
It was estimated that hedge funds held assets valued at about $1.7 trillion in
September 2008, but during the third quarter they collectively lost some $210
billion. Hedge fund investors pulled out some $100 billion by September 24,
2008, and put the funds into money markets, seeking a safe haven. In October
2008, at the height of the subprime crisis, hedge funds lost some $115 billion
in asset values as redemptions totaled $40 billion. The industry braced for
massive year-end redemptions. JPMorgan Chase estimated that redemption
requests by hedge fund investors in the fourth quarter of 2008 totaled $100
billion. The number of hedge funds had been increasing until the subprime
crisis, but their number shrank by 4 percent during 2008.

Highbridge Capital Management, created by JPMorgan Chase, collected $15

billion for investment, but by December 2008 that fund’s assets had dwindled
to $6 billion as a result of losses and investor redemptions. On December 3,
2008, JPMorgan Chase seized the collateral of Guggenheim Partners, a hedge
fund whose investors included CalPERS that invested in commercial property
debt. The average loss for hedge funds in 2008 was 29 percent. Still, some
hedge fund managers did quite well that year. The top twenty-five of them
made a total of $11.6 billion. James Simons, the manager of the Renaissance
Technologies hedge fund and a former math teacher, made $2.5 billion; John
Paulson at Paulson & Company had a $2 billion gain; John Arnold at Centau-
rus Energy made $1.5 billion; and George Soros, the manager of Soros Fund
Management, made $1.1 billion. Hedge funds still managed some $1.6 tril-
lion as 2009 began, and economists forecast that hedge funds would provide
a market-beating overall return of 5 to 10 percent in 2009. By the second half
of 2009 hedge funds seemed to recover. Investors returned to the larger hedge
funds, like Blackstone Group, which reported strong earnings in the second
quarter of 2009. KKR made a successful public offering of one of its proper-
ties, Avago Technologies. Fortress Investment Group also reported improved
earnings in the second quarter.
The subprime crisis resulted in another reversal of course on hedge fund
regulation. After some Enron-era scandals, the SEC required hedge funds to
register as investment advisers. That rule was set aside by a federal appeals
court, and further government study concluded that registration was unneces-
sary. Nevertheless, Treasury Secretary Henry Paulson announced, somewhat
surprisingly, on November 20, 2008, that ongoing efforts in regulatory reform
should include a requirement that hedge funds register with the government and
be subject to regulatory oversight. The Obama administration also advocated
such regulation. The reason for this change in direction was unclear, other
than the fact that some hedge funds had lost a lot of money for their extremely
wealthy investors. Congress was engaged on the topic, grilling several large
hedge fund managers in November 2008 in order to determine how their opera-
tions might affect the economy and to examine their compensation arrange-
ments. Further support for regulation was lent by a study at the Stern School
of Business at New York University, which concluded in October 2009 that
20 percent of hedge fund managers misrepresented the amount of funds under
management, performance records, and regulatory problems. The hedge funds
are regulated under the Dodd-Frank Act that was passed in July 2010.
Hedge fund regulation was also a hot topic in Europe. The European Union
proposed requiring hedge funds to register and disclose their operations. At
their meeting in London in April 2009, finance ministers of the Group of
Twenty considered the issue of how to regulate hedge funds. The United
States and the UK advocated greater disclosure, while Germany and France
supported regulating hedge funds in the same way as banks. The United States
and the UK lobbied the EU to drop some of its more onerous proposals for

hedge funds and private equity, such as leverage limitations and stiff capital
requirements.
Venture Capital
Angel investors and their incubator loans made themselves scarce as the sub-
prime crisis deepened, cutting off a crucial source of cash to high-tech startups.
Angels invested $26 billion in start-ups in 2007, but only $19.2 billion in
2008, when about 55,000 ventures were funded, with an average investment
of about $346,000. The subprime crisis also had an adverse impact on venture
capital. Venture capital (VC) investment was only about $30 billion in 2007,
which was the size of some single private equity transactions. VC firms raised
about $31 billion in 2008, but the subprime crisis caused many large investors
to seek cutbacks in their capital commitments. Some investors had difficulty
meeting their capital calls as the credit crunch and subprime crisis worsened.
Washington Mutual missed capital calls from VC firms after it failed, and it
faced harsh penalties and interest payments because of those breaches.
Only $5.5 billion was invested by venture capitalists in the fourth quarter of
2008, a decline of 30 percent compared with a year earlier and the lowest level
since 2005. In 2008, only about 440 venture capital investments were made,
with an average investment of $7.5 million. The first quarter of 2009 saw a
further decline, down to $3 billion, the lowest amount since 1997. A popular
venture capital exit strategy, the initial public offering (IPO), also virtually
stopped during the subprime crisis. Only fifty-six IPOs were conducted in the
first quarter of 2009.
In 2008 and the first half of 2009, the number of venture capitalists shrank
by 15 percent. VC investments fell by 50 percent in the second quarter of
2009. Some venture capitalists changed their investment approach and in-
vested in distressed assets and even stock of large public companies that had
been decimated during the subprime crisis. Many venture capitalists cut their
fees sharply to attract investors. They sought funds from the massive stimu-
lus package passed by Congress early in the Obama administration. Among
other things, that package sought to encourage environmental technology,
rural Internet access, and health-care information systems. Venture capitalists
invested some $513 million in environmentally friendly enterprises in the first
half of 2009, but that was only a quarter of the amount in the first half of 2008.
CalPERS supported the venture capitalists’ efforts in this field, investing $260
million in two VC funds.
Al Gore, the vice president under Bill Clinton, attracted attention as a partner
in Kleiner Perkins Caufield & Byers. He secured billions of dollars in stimulus
package funds for “smart grid” programs for utilities that were clients of his
firm. The Energy Department disbursed more than $40 billion to companies
working on clean technology, and this attracted venture capitalists. In a Wall
Street Journal op-ed published on November 5, 2008, Gore decried the state of

capitalism in the United States, saying that business was too heavily focused
on short-term quarterly earnings and charging that the country was engaged
in “rampant consumerism” and was “living beyond our means.” He advocated
what he called “sustainable capitalism,” to be driven by something other than
fossil fuels.2
The Obama administration tried to regulate the venture capitalists as invest-
ment advisers, asserting that they posed a systemic financial risk. Actually,
venture capitalists were too small and too important to be regulated. Regulation
adds large amounts of costs, tends to stifle innovation, and seeks to discourage
risk taking. As the Wall Street Journal pointed out, some 20 percent of gross
domestic product (GDP) was created by companies that had been aided by
venture capital in their formative years. Although it regulated hedge funds in
2010, Congress exempted venture capitalists from registration.3
Every field of finance has some fraud, and venture capital is no excep-
tion. Venture capitalist William Del Biaggio was sentenced to ninety-seven
months in prison in September 2009 for defrauding investors in his VC fund
of nearly $50 million. Biaggio and his co-defendant, Scott Cacchione, who
also pleaded guilty, misappropriated investor funds and falsified brokerage
records to obtain bank loans.
Dealing with Chaos
The Crisis Rolls On
The creation and implementation of TARP did not immediately stop the on-
going subprime crisis on Wall Street. Many companies drew down on their
revolving lines of credit to build up their cash reserves and obtain credit that
was otherwise unavailable during the subprime crisis. Bank depositors flocked
to the banks that appeared the strongest. The stock market remained volatile
even after the approval of TARP. The Dow Jones Industrial Average closed
down 76.62 points on October 14, 2008, after rising 400 points during the
trading day. The market resumed its downward plunge on October 15, 2008,
when the Dow fell by 733 points. Investors lost more than $1.1 trillion in
stock values in that freefall, the second-largest point drop ever for the Dow
and the worst percentage-point drop on a single day since 1987. The Dow was
then nearly 40 percent lower than its high. The S&P 500 also experienced its
largest single-day drop since the stock market crash in 1987. Continuing bad
news propelled this market freefall.
Mortgage markets were frozen. The average fixed-rate interest for thirty-
year home loan mortgages on October 15, 2008, was 6.75 percent, an increase
over the 6.06 percent of the previous week. JPMorgan Chase and Wells Fargo
announced sharp declines in their third-quarter earnings that day. They also
warned that loan delinquencies were increasing. The price of crude oil fell
below $75 a barrel as well, about half its price in July. Citigroup reported a

third-quarter loss of $2.82 billion on October 16, 2008, and that news spurred
another wild day on Wall Street. The Dow fell by 816 points during the day,
but finished up 401.35 points. Crude oil prices fell below $70 a barrel, other
commodity prices appeared to decline, and inflation diminished. Amazingly,
during the week ending October 17, 2008, the Dow Jones had its best perfor-
mance since 2003.
Standard & Poor’s downgraded the credit ratings for 760 classes of eighty-
five issues of Alt-A mortgage-backed securities on October 20, 2008. Many of
those classes were reduced to junk bond status because the value of the prop-
erties backing them had fallen to less than their mortgage amounts. Synthetic
CDOs, which allowed firms to invest in a diversified portfolio of corporate
debt without actually buying the underlying bonds, raised more concerns in
October 2008 because losses were mounting for the purchasers of such instru-
ments. Many of those CDOs were written on financial firms.
The stock market jumped on October 20, 2008. The Dow rose by 413.21
points, but fell back 231.77 points the next day, and by another 514.45 points on
October 22, 2008, when crude oil prices dipped by $5.43 per barrel, to close at
$66.75. Stock market volatility continued on October 23, 2008, after the Dow
rose by 172.04 points. The commercial paper market shrank substantially after
the Reserve money market fund fell below $1 per share (“broke-the-buck”)
as the result of its holdings of bankrupt Lehman Brothers commercial paper.
Other money market funds stopped making commercial paper investments,
which then resulted in illiquidity in that market.
A hastily arranged government program to protect the commercial paper
market was arranged over the weekend of October 18 and 19, 2008. On October
21, 2008, the Fed announced that it was providing $540 billion to insure and to
buy commercial paper from the money market funds, which were being pressed
by redemption requests from fearful investors. The money market funds held
about $3.5 trillion in assets. Pimco agreed to manage the government’s efforts
to enter the commercial paper market. The Fed expanded this program and
bought, in total, $845 billion in short-term debt from U.S. companies during
the first three days of the operation of its commercial paper funding facility.
This effort seemed to work. The Fed announced on November 10, 2008, that
it would delay further purchases of money market assets because the com-
mercial paper market appeared to stablize.
The stock of American Express had fallen 55 percent in October 2008 year
on year. The company’s troubles worsened after it reported a 24 percent decline
in profit in the third quarter. AmEx then cut 10 percent of its workforce and
requested $3.5 billion from the TARP bailout program. In order to qualify
for TARP funds and loan facilities, AmEx became a bank holding company,
as did Discover Financial Services. Credit card delinquencies had increased
at AmEx and other credit card companies. Notwithstanding those problems,
AmEx’s CEO, Kenneth Chenault, was paid $42.8 million in 2008.
Goldman Sachs announced the dismissal of about 10 percent of its work-

force on October 23, 2008. Insurance companies started to show the strain
of the market turmoil in that month. The stock price of some large insurers
tumbled by more than 30 percent. Large insurance companies raised capital
in anticipation of even larger losses. Some insurance companies bought small
banks in order to qualify for payments from the TARP program.
Greenspan
Alan Greenspan had been a rock star as Fed chairman, but he lost his luster in
retirement as blame settled on him for laying the groundwork for the subprime
crisis. Many critics claimed that the reduced interest rates implemented after
the stock market bubble burst in 2000 set off the housing bubble. Greenspan
rejected warnings from economists in 2004 of a growing bubble in the hous-
ing market. He responded to those concerns by stating that housing prices had
never experienced a nationwide decline and that a crisis in that market was
unlikely. Furthermore, while he was Fed chairman he had blocked a proposal
for closer supervision of subprime lenders.
The New York Times blamed the subprime financial crisis on the use of
derivatives, which Greenspan had supported. A front-page story on October
9, 2008, quoted Greenspan as saying in 2004: “Not only have financial institu-
tions become less vulnerable to shocks from underlying risk factors, but also
the financial system as a whole has become more resilient.” Greenspan was a
believer in the use of derivatives for purposes of risk management, while other,
old-line financiers like George Soros, Warren Buffett, and Felix Rohatyn had
decried the use of these complex instruments. Buffett called them “financial
weapons of mass destruction.”4 Supporters of derivatives responded with
claims that derivatives were actually “smart bombs.”5 Among Greenspan’s
other critics was Paul Volcker, who preceded him as Fed chairman and later
became an economic adviser to presidential candidate Barack Obama.
A chastened Greenspan testified before the House Committee on Oversight
and Government Reform on October 23, 2008. The country, he said, was “in
the midst of a once in a century credit tsunami,” admitting that free-market
competition doctrines had not prevented the subprime crisis. He testified that
a “central pillar” of the financial system was the monitoring of counterparty
risk by parties to transactions, but that fundamental protective mechanisms
had failed. The problem, as he saw it, was undisciplined mortgage lending,
which left him in a state of “shocked disbelief.” In his words, he had made
a “mistake” in not engaging in more affirmative regulation.6 He cautioned
against burdening financial intermediation with heavy regulation but urged
higher capital requirements for banks, as did his successor as Fed chairman,
Ben Bernanke, the previous day.
Before this, Greenspan had been given respectful, even deferential treat-
ment before congressional committees. Those days were over. In response
to the congressional grilling, Greenspan then reverted to his turgid and con-

voluted diction in his testimony. He recovered his composure, however, and

replied some months later with an op-ed in the Wall Street Journal in which
he defended his reign as Fed chairman. Greenspan asserted that the residential
housing bubble was caused by global forces over which U.S. policymakers,
like himself, had little control. He also called for wider prosecution of fraud,
which was an obvious effort to find scapegoats to divert attention from his
policy failures.7
Greenspan was not the only former government official blamed for the
subprime crisis. Another front-page New York Times article charged that former
senator Phil Gramm (R-TX) was responsible for much of the deregulation of
financial services that was now being blamed for causing the subprime crisis.
Gramm was unrepentant.8 He explained in a Wall Street Journal op-ed that
the legislation that he had sponsored did not encourage or facilitate subprime
lending.9 He noted that the repeal of the Glass-Steagall Act, which prevented
commercial banks from engaging in investment banking activities, by the
Gramm-Leach-Bliley Act in 1999 did not introduce subprime lending because
banks already had the power to engage in such activity. The banks were also
already empowered to securitize mortgages before that repeal. Gramm had
long been an opponent of the Community Reinvestment Act, which had forced
commercial banks to engage in subprime lending.
More Market Volatility
Markets worldwide plunged on October 24, 2008. The S&P 500 was down
3.5 percent on that day. The Dow fell by 312 points, falling to 8378.95, a
five-year low. The housing market experienced the sharpest decline on record
that month as existing home sales dipped at an annualized rate of 3.1 percent
despite declining prices. The giant home builder Toll Brothers saw its orders
contract by 27 percent in October 2008 over those from October 2007, that
is, for the company’s fiscal year; its revenues were down 41 percent for its
final quarter of FY2008.
The housing industry proposed a program called “Fix Housing First” that
was intended to jump-start the housing industry by giving home purchasers
a tax credit up to $22,000 and a subsidized interest rate of 2.9 percent on a
thirty-year fixed mortgage. It was estimated that such a program would cost
taxpayers $268 billion. JPMorgan Chase announced on October 31, 2008,
that it would modify the terms of $70 billion in delinquent mortgages by
lowering interest and principal amounts. This program would affect 400,000
borrowers, constituting about 5 percent of JPMorgan’s mortgage portfolio.
JPMorgan acquired $16 billion of subprime mortgages when it took over
Washington Mutual.
Nationwide, more than 7 million mortgages were expected to default in the
next two years. Sheila Bair, chair of the Federal Deposit Insurance Corporation
(FDIC), promoted a program in October 2008 to assist homeowners in meeting

their mortgage payments. She thought that providing financial incentives to

banks to modify distressed mortgages by making their terms more affordable
would help restore the mortgage business. Bair had other problems on her
plate. National City Corporation, a Cleveland-based bank, suffered large losses
from subprime mortgages and had announced in January 2008 the reduction
of its dividend by 49 percent and the search for a buyer in March. National
City appeared to right itself after it announced in April 2008 the receipt of a $6
billion infusion of capital from private equity investors led by Corsair Capital.
As a part of the transaction, the private equity investor received shares in the
bank at prices well below the existing market. National City was denied a
capital injection by the Treasury Department, however, so that equity infusion
provided only short-term relief, and regulators put together a deal with PNC
Financial Services Group, which bought the crippled National City for $5.58
billion on October 24, 2008.
Crude oil prices fell to $64.15 on October 24, 2008. The next day, the
Organization of Petroleum-Exporting Countries (OPEC) announced a cut in
production of 1.5 million barrels a day, the largest in eight years. That move
was viewed as a sign of weakness in the market, leading crude oil prices to
continue to fall, as much as 33 percent in October. U.S. consumer prices fell
by 1 percent in October 2008, the largest single month of decline since World
War II, raising the specter of deflation. Retail sales declined by 2.8 percent
that month, the largest drop since figures began to be kept. Sales at Neiman
Marcus plunged by 28 percent in October compared with the previous year.
Circuit City was headed to bankruptcy court. The U.S. unemployment rate
was at a fourteen-year high of 6.5 percent that month. By the end of October,
the number of jobs lost up to that point reached 1.2 million.
Volatility returned to the stock market. The Dow lost 203.18 points on October
27, 2008, another five-year record. But the next day, it closed up 889.35 points,
in the second-largest increase in its history, the largest increase having occurred
on October 13, 2008, to close at 9065.12. The following day it fell once more,
losing 74.16 points, in volatile trading. Then, two days of rising, by 189.73 points
on October 30, 2008, and by 144.32 points on October 31. An article in the New
York Times declared that volatility in October 2008 made it the “wildest month
in the history of Wall Street.”10 For the month, the Dow was down 14 percent,
its worst performance in more than ten years. It was also the worst month for
the S&P 500 Index since the stock market crash of 1987, which also occurred
in October. The securities lending market dried up at the end of October 2008,
causing large losses. Investors withdrew some $72 billion from equity mutual
funds that month. Fidelity Investments announced the layoff of 1,300 members
of its workforce and of a further 1,700 over the next three months.
As a result of market declines, the defined benefit pension plans of many
large companies suffered massive losses, estimated at some $250 billion for
the one-year period ending October 31, 2008. Private pension funds that had
previously been fully funded were now underfunded. State pension funds

were also in trouble, losing, on average, about 14.8 percent of their value in
the first three quarters of 2008. About 40 percent of state pension funds were
then underfunded. CalPERS lost about 20 percent of its value between July
and October 2008, totaling almost $40 billion. CalPERS also had liquidity
problems and sold stock holdings in a declining market in October 2008 in
order to raise cash for obligations to private equity firms.
The Fed lowered interest rates by 0.50 percent on October 29, 2008, bring-
ing the Fed funds rate down to 1 percent. China, Norway, and several other
countries also cut their interest rates. The Fed examined credit concerns with
respect to two hedge funds, the Citadel Investment Group and Sankaty Advi-
sors, a hedge fund associated with Bain Capital, a private equity firm.
The furor over executive compensation continued, aided by a Wall Street
Journal report on October 31, 2008, that financial institutions receiving
bailout money owed their executives more than $40 billion in bonuses and
pensions. The report noted that payments owed to executives at some of these
firms exceeded the amount owed to the entire rest of the workforce. Goldman
Sachs owed its executives $11.8 billion and Morgan Stanley more than $10
billion. Seven senior executives at Goldman Sachs, including its CEO, Lloyd
Blankfein, thereafter relinquished any bonuses for 2008, even though the firm
remained profitable. However, Goldman Sachs was expected to report a loss
for the first time as a public company in the fourth quarter of 2008.
Gold prices fell to just over $700 per ounce as October ended, down from
a peak of more than $1,000 per ounce in March 2008. Issuance of commercial
paper increased for the first time in seven weeks on October 30, 2008. Sales
of longer-term commercial paper started to rise as November 2008 began, as
a result of Fed purchases in that market. At that time, about $67.1 billion in
commercial paper had maturities of more than eighty days outstanding, up
from $6.7 billion before the Fed intervened. The Fed supplied about $60 bil-
lion of the former amount. Defaults were up in the repurchase (repo) market
in the first week of November 2008.
On Election Day, November 4, 2008, the Dow Jones Industrial Average
rose by 305.45 points reaching 9625.28. However, the next day it suffered its
worst percentage loss in history. That average fell again, by 443.48 points, on
November 6, 2008, for a total of 929.49 points on those two days, the largest
two-day drop since the stock market crash of 1987. On November 7, 2008, it
rose by 248.02 but was still down by 4.1 percent for the week.
Regulators seized two banks over the weekend of November 8 and 9,
2008. One of those banks was Franklin Bank—a leader in packaging and
selling mortgage-backed securities—in Houston, Texas, which was then sold
to another Texas bank, Prosperity Bank. However, the FDIC was left with
$4.25 billion in assets from Franklin Bank that it would have to dispose of in
a very troubled market. The other failing bank, the nineteenth bank failure for
the year, was Security Pacific Bank in Los Angeles, which had suffered large
losses from loans to home builders in California.

More banks would fail if predictions by economists that the United States
was facing the worst recession since World War II were borne out. On No-
vember 7, 2008, President-elect Barack Obama introduced to the public a
brain trust of advisers on the economy that included many former Clinton
administration officials, such as Robert Rubin, Lawrence Summers, and Robert
Reich. Thereafter, Obama announced the creation of an Economic Recovery
Advisory Board, headed by former Fed chairman Paul Volcker, that would
advise the president on actions needed to end the subprime crisis. Volcker was
also chairman of the prestigious Group of Thirty Financial Reform Working
Group, which issued a report in January 2009 advocating increased regulation
of financial services in a two-tiered regulatory structure: a more stringent one
for large institutions and one with lighter regulation for smaller institutions.
This recommendation marked a reversal of the deregulation of larger institu-
tions that had been in place since the 1980s.
In the fourth quarter of 2008, the Treasury Department borrowed a record
$550 billion, needed to support its rescue efforts as well as other government
expenditures. Adding to the crisis in November 2008 was the fact that the
banks were continuing to tighten their lending standards, further worsening
the credit crunch. It was also estimated in November 2008 that as many as
one in six homes might be “underwater,” meaning that the house was worth
less than the mortgage. Fannie Mae and Freddie Mac announced on Novem-
ber 11, 2008, attempts to ease the burden by modifying loans for hundreds of
thousands of homeowners who were delinquent on their mortgage payments
by ninety days or more.
Edward J. Pinto, the former chief-credit officer at Fannie Mae, advised Con-
gress on December 9, 2008, that Fannie Mae and Freddie Mac guaranteed or
held 10.5 million subprime loans covering $1.6 trillion in debt, or one in three
subprime loans. The two agencies also held two-thirds of outstanding Alt-A
mortgages. Those two groups of mortgages (subprime and Alt-As) comprised
34 percent of the residential mortgage portfolios at Fannie Mae and Freddie
Mac. Pinto predicted that mortgages held by the two institutions would result
in 8 million foreclosures. Freddie Mac announced a $25.3 billion quarterly loss
on November 14, 2008, and stated that it would need government infusions
of $13.8 billion to shore up its finances.
Failed financial institutions were under attack. It was noted pointedly in
congressional testimony that Fannie Mae and Freddie Mac spent $179 million
on lobbying expenses over the prior ten years in order to stave off additional
regulation. In what had become a clearly defined pattern for any major busi-
ness failure, the FBI was conducting criminal investigations of the failures of
Fannie Mae, Freddie Mac, Lehman Brothers, and AIG.
The Dow Jones Industrial Average fell by 411.30 points on November 12,
2008. Crude oil prices closed at $56.16 a barrel that day. Morgan Stanley an-
nounced a layoff of 2,500 employees. Enterprise Car Rental cut 1,000 jobs,
the first layoff in the fifty-year-old firm’s history. The New York law firm of

White & Case laid off seventy attorneys in November 2008. The law firms of
Clifford Chance, Katten Muchin, and Sonnenschein also laid off a number of
associates—almost unprecedented in large law firms. Other law firms froze
associates’ salaries and required capital contributions from partners, and some
firms, such as San Francisco’s Brobeck, Phleger & Harrison, which had em-
ployed some 900 lawyers, closed their doors.
The federal government began its fiscal year in November 2008 with a re-
cord $237 billion deficit. The Treasury Department announced on November
12, 2008, that it was shifting its focus under TARP to help consumers because
the banks refused to extend loans, despite the TARP capital infusions and
liquidity efforts by the Fed. The New York Times reported that even smaller
community banks that had been given money from the bailout were not us-
ing it for lending. For example, the Independent Bank of Michigan was given
$72 million in capital from TARP funds but used it to repay short-term loans
from the Fed.11
The Treasury proposed the investment of TARP funds in a facility that
would help companies involved with student loans, automobile financing,
and credit cards. Adding uncertainty, and concern, to the market was the con-
firmation by Treasury Secretary Paulson that TARP funds would not be used
to purchase troubled assets from banks. Rather, he indicated that he would
keep the remaining funds on hand, after expending $350 billion of the $700
billion allocated, to meet future emergencies. Even the $350 billion that was
expended went into capital injections instead of asset purchases, even though
the TARP program had been sold to Congress as an asset-purchasing measure,
as indicated by the program’s name—Troubled Asset Relief Program.
Although much concern was being expressed at the lack of bank lending,
the banks claimed to be lending at record levels in the first two weeks of
November. Their commercial and industrial loans increased 15 percent over
the year before and grew by 25 percent, at an annual rate, in the third quarter
of 2008. Home equity loans increased 21 percent over a year earlier, for an
annualized rate of 48 percent. However, the credit markets seized up once
again on November 20, 2008.
Stock market volatility continued. The Dow increased by 552.59 points
on November 13, 2008, but fell 337.94 points the next day. The Dow had a
combined loss of more than 560 points on November 16 and 17, 2008, but
rose by 151.17 on November 18, 2008, in volatile trading. November 19,
2008, was another bad day on Wall Street. The Dow declined by 427.47
points, falling below 8000, its lowest close since March 31, 2003. Crude
oil prices dropped below $50 a barrel on November 20, 2008, but the Dow
lost 444.99 points. On November 20, the price of Goldman Sachs stock fell
below $53 per share, the same as its IPO. Goldman’s stock was down by 75
percent for the year. Large job cuts were announced by Bank of New York
Mellon and JPMorgan, which had already cut 5,000 jobs after acquiring Bear
Stearns earlier in the year.

The delinquency rates on commercial mortgages rose. Commercial mort-

gage-backed securities, comprising a market of $800 billion, seemed headed
for defaults. By November 20, 2008, the S&P 500 Index was 52 percent
lower than its record high in 2007. The Dow fell 47 percent compared with
the record it had set in 2007. In total, $8.3 trillion in stock market values had
been lost since that benchmark. This was the worst decline for the Dow since
the bear market in 1937 and 1938. Investors sold stocks and bought Treasury
securities for safety, pushing the prices of those government securities to a
thirty-five-year high. Market commentators also thought that forced selling
was hurting the market.
The stock market rallied strongly after it was disclosed that President-elect
Obama had selected Timothy Geithner to be his treasury secretary. Geithner
was then serving as president of the Federal Reserve Bank of New York and
had been deeply involved in handling the subprime crisis with Bernanke and
Paulson. However, Geithner’s nomination created some embarrassment after
it was discovered that he had failed to pay over $34,000 in Social Security
and Medicare taxes while he was employed at the International Monetary
Fund (IMF). Geithner owed those taxes because the IRS viewed him as self-
employed, which seems odd but required him to pay his own Medicare and
Social Security taxes. Some of his tax deductions were also challenged. The
basis for some of these challenges was fairly technical, but, as treasury secre-
tary, he would have responsibility for oversight of the IRS so every tax-related
transgression was explored. Geithner also had employed a housekeeper for
three months after her immigration permit had expired.
Such charges had derailed other cabinet nominations in the past. James
Landis, who had served as Securities and Exchange Commission (SEC) chair-
man for a time under President Franklin Roosevelt and as dean of Harvard
Law School, was even sent to jail for a month after it was discovered, during
a background check for an appointment in the administration of John Kennedy
in 1960, that he had failed to file tax returns for five years. Some other Obama
administration nominations did not fare as well as Geithner’s. Former senator
Tom Daschle (D-SD) had to withdraw his nomination as secretary of health
and human services after it was disclosed that he had failed to pay more than
$120,000 in taxes on the benefits of a car and driver provided to him by one of
his supporters, the owner of a private equity group. Another nominee, Nancy
Killefer, who was nominated to the new position of “chief performance officer
. . . to improve the efficiency and accountability of government agencies,” also
had to withdraw her nomination after it was disclosed that she had failed to
pay $950 in taxes for a part-time employee.
Home builders sought a $250 billion stimulus package from Congress in
November 2008 as a means of jump-starting the housing market. Sheila Bair,
chair of the FDIC, urged the creation of low-cost government loans to support
borrowers who defaulted on their high-cost subprime mortgages. Working
through the Treasury, she tried to persuade the Bush administration to propose

a $40 billion bailout for troubled mortgages. It initially appeared that she was
successful, but the Bush administration backed off that proposal a few weeks
later. A study by the Office of the Comptroller of the Currency in December
2008 found that half of homeowners fell behind again on mortgage payments
in the first six months after their loans were modified to make their mortgages
more affordable.
The FDIC sought to allow large banks to return to the medium-term note
market for funds by announcing on October 14, 2008, that it was creating a
Temporary Liquidity Program, which would involve an FDIC guarantee of
unsecured bonds issued by large banks. The guarantee would extend to loans
with a maturity of as much as three years, but not commercial paper with a
maturity of less than thirty days. However, the FDIC program did not get
off the ground until November 21, when the government announced that the
guarantee would have the full faith and credit of the United States, not just
the FDIC.
Grand Canyon Education launched an IPO on November 20, 2008, the first
IPO in fifteen weeks, but it closed down from its offering price. Three more
banks—two California thrifts and a Georgia community bank—failed on No-
vember 21, 2008. Saudi Arabia cut interest rates on November 23, 2008, and
lowered bank reserve requirements as it began to feel the effects of declining
oil prices. Its stock market had also plunged. The Group of Twenty meeting
in Washington, DC, in November 2008 did not make much progress in creat-
ing an international regulatory system, which the United States resisted. The
conference members did agree that there should be an effort to stop reckless
market behavior, which it left undefined.
More Citigroup Problems
As of November 2008, Citigroup had assets on its balance sheet valued at $2

trillion, including some $20 billion in mortgage-related securities marked down
to between twenty-one and forty-one cents on the dollar. Citigroup also had
another $1.23 trillion in assets in entities that were not on the balance sheet,
some of which were tied to the mortgage market. It had previously moved
$35 billion of those assets onto the balance sheet and planned to move an
additional $122 billion back onto that statement. It announced on November
19, 2008, a buyout of the remaining $17.4 billion in assets held off its balance
sheet in structured investment vehicles (SIVs), causing it to take a $1.1 billion
writedown. Citigroup’s stock price fell by 23 percent on that day.
In September 2008, Goldman Sachs had discussed a possible merger with
Citigroup but that overture was rejected, presumably to the bank’s regret.
Instead, Citigroup CEO Vikram Pandit reported on November 17, 2008, that
Citigroup would cut 25,000 more jobs, pushing the total during the subprime
crisis to 50,000. Many of those jobs were lost as a result of the sale of various
Citigroup units to other companies. Citigroup teetered on the brink of collapse,

and its share price was at a sixteen-year low that month. The bank’s market
capitalization had fallen to $20.5 billion, down from $244 billion in 2006.
Despite the announcement of a further capital injection from Prince Al-
Waleed bin Talal of Saudi Arabia, Citigroup’s shares plunged by 26 percent
on November 20, 2008. For its part, Citigroup blamed the decline of its stock
price on short-sellers and urged the SEC to restore the uptick rule for short
sales. Citigroup officials began to discuss with federal regulators what actions
the bank could take to stop the precipitous decline in its stock price. By this
point, Citigroup had posted losses and writedowns of over $65 billion.
For the week ending November 21, 2008, Citigroup’s stock price fell by
more than 60 percent. The Treasury Department stepped in over the weekend
of November 22 and 23, 2008, to arrange a rescue of the bank. It initially
considered guaranteeing Citigroup’s toxic assets by creating a “bad” bank
to take those assets off the Citigroup balance sheet. The toxic assets would
then receive some form of government backing. This arrangement worked
successfully in the 1980s in connection with the failure of First City National
Bank of Houston. The FDIC created a $1 billion “bad bank” for that bank’s
distressed energy and commercial real estate assets, which were liquidated
over several years. However, the “good bank,” which held First City’s good
assets, subsequently failed again. The same approach was taken for Mellon
Bank of Pittsburgh. Its distressed assets were sold to a “bad bank,” owned
by private investors in a group called Grant Street National, and those assets
were ultimately sold for a profit.
Sweden implemented such a program in the 1990s during a financial crisis.
The government nationalized the country’s ailing banks and placed their dis-
tressed assets into what was called a “bad bank,” and those assets were sold
off in an orderly liquidation process. The remaining “good banks” were given
capital to resume their operations, and the situation stabilized.12 However, that
restructuring did not shield Sweden from the subprime crisis. In October 2008,
Sweden announced the guaranteeing of $200 billion of its banks’ debt, equal
to about 50 percent of the country’s GDP.
In the end, the Treasury Department rejected such an approach for Citi-
group. Rather, it injected the bank with $20 billion in capital on November 24,
2008, in addition to the prior $25 billion in an earlier injection. The Treasury
Department also agreed to guarantee up to $306 billion of mortgage-backed
investments and leveraged commercial loans owned by Citigroup. Under this
arrangement, Citigroup was required to pay the first $29 billion in losses on that
portfolio. Thereafter, the government would absorb 90 percent of any remain-
ing losses up to $249 billion. In exchange for this further bailout, Citigroup
was required to issue another $7 billion in preferred stock to the government,
on which Citigroup would pay a dividend.
The federal government was now Citigroup’s largest shareholder, owning
7.8 percent of the bank. Government officials began using their control over
Citigroup to exercise veto power over new acquisitions, and the bank was under

minute examination by bank examiners assigned to its offices. The Treasury

Department also took over control of Citigroup’s compensation practices,
limiting bonuses to senior executives for 2008 and 2009 to no more than 60
percent of the previous year’s bonuses. In addition, at least 50 percent of 2008
bonuses were to be paid in deferred stock or deferred cash payments.
Citigroup’s problems were attributed to its failure to take over Wachovia
and expand its retail business—a failure viewed, by the market, as evidence
of structural weakness by Citigroup’s management. Management problems
continued at the bank. As an interim measure, Robert Rubin became head of
the Citigroup executive committee, and Sir Win Bischoff, head of Citigroup’s
European operations, became chairman of the board. However, Rubin was later
pushed aside after his role in steering Citigroup toward more risky investments
was revealed. He was then demoted to “senior counselor” at Citigroup and
relinquished his role as chairman of the bank’s executive committee.
President-elect Obama made Rubin one of his host of economic counsel-
ors to deal with the ongoing subprime crisis in November 2008. However,
a front-page article in the New York Times on November 23, 2008, revealed
Rubin’s role in pressing Citigroup executives to take on greater risks in order
to increase profits.13 Former CEO Charles Prince bought into that program
fully, and that set the stage for the subprime debacle. Rubin defended himself
in an interview for a front-page article in the Wall Street Journal,14 in which
he denied having had operational responsibilities for risk management though
admitting that he had encouraged increased risk taking by the bank in 2004
and 2005. That admission seemed to conflict with his public statements during
the period that investors incurred too much risk. In the event, Rubin resigned
from Citigroup on January 9, 2009.
Citigroup was dismantling the financial supermarket that had been built by
Sandy Weill. On January 13, 2009, Citigroup announced that it was selling
several of its businesses including consumer finance units and its private label
credit card, and it was cutting back on its trading activities. Later, in January
2009, Citigroup spun off its Smith Barney brokerage unit, one of its crown
jewels, into a joint venture with Morgan Stanley. Morgan Stanley later took
control of all of Smith Barney.
Government Action
Economic problems continued abroad, requiring further government interven-

tion. The UK announced on November 24, 2008, the adoption of a $30 billion
stimulus package involving expenditures for infrastructure and tax cuts. The
following day, the government assumed majority control of the Royal Bank
of Scotland. The European Union announced a $280 billion plan to increase
spending in an effort to avoid a deep recession. Poland planned a $31.4 billion
stimulus package for its economy at the end of November.
Back in the United States, Fannie Mae and Freddie Mac announced on

November 20, 2008, that they would suspend mortgage foreclosure sales
and evictions during the holiday season. Fannie Mae issued long-term debt
in November 2008 but paid a high-risk premium for its issuance, raising $2
billion. The Fed lent further support on November 25, 2008, by agreeing to
buy $600 billion of debt issued by Freddie Mac and Fannie Mae.
After news spread of the government’s latest bailout of Citigroup, the Dow
Jones Industrial Average jumped by 494 points on November 21, 2008, and rose
another 396.97 points on November 24, 2008. President-elect Obama proposed
a $500 billion stimulus package that he claimed would create 2.5 million jobs
through increased spending on infrastructure and green projects.
The commercial real estate securities market fell back in record amounts dur-
ing the week of November 21, 2008. A $1.5 billion hedge fund that invested in
such securities—whose investors included H. Ross Perot, the Texas billionaire
and former presidential candidate—suffered enormous losses. Petra Capital
Management, a $2 billion hedge fund that invested heavily in commercial real
estate securities, faced huge margin calls. Another such fund, Guggenheim
Partners, made a $300 million capital call on its investors.
On November 25 and 27, 2008, the two days before the Thanksgiving
holiday, Morgan Stanley and JPMorgan Chase sold $17.25 billion of the re-
cently authorized FDIC guaranteed bonds. Bank of America made a $9 billion
offering of such bonds on December 1, 2008. General Electric planned such
an offering, as did Citigroup. These bonds were said to be synthetic Treasury
bonds because they were fully guaranteed by the federal government, but
which offered a higher rate than those issued by the Treasury directly. Finan-
cial analysts predicted that such offerings would be used to raise over $250
billion that would mature in the first six months of 2009; in fact it reached
$336 billion in March 2009. The program was extended in February 2009 to
include mandatory convertible debt.
The Federal Reserve Bank of New York announced the creation of a new
facility that would purchase up to $200 billion in newly issued, triple-A-rated,
securitized student and automobile loans, credit card receivables, and small-
business loans guaranteed by the Small Business Administration. This was to
be done through a new program called the Term Asset-Backed Securities Loan
Facility (TALF), in which the New York Fed would make nonrecourse fully
secured loans that would use a special-purpose vehicle (SPV) to purchase the
loan collateral from the bank. TARP would initially fund the SPV by purchas-
ing $20 billion in subordinated debt that it issued. That announcement caused
a drop in interest rates even though the government cautioned that it would
take some time to launch the TALF program. The rate on a thirty-year fixed
mortgage fell to 5.5 percent, resulting in a surge in mortgage refinancing. It
also rallied the stock market.
By the end of November 2008, the federal government had lent $1.7 trillion
to financial firms that were using mortgage-backed securities as collateral for
those credit extensions. The government had also agreed to buy stock, corporate

debt, and mortgages totaling $3 trillion. The government made another $3.1
trillion in guarantees for corporate bonds, money market funds, and increased
FDIC deposit account insurance.
More Losses
In year ending December 2008, Swiss Reinsurance (Swiss Re) wrote off
$2.47 billion on credit derivative investments; in the first eleven months of
that year alone, its share price fell by 38 percent. Deutsche Bank spurned a
bailout from the German government and showed a profit in the third quarter
of 2008. Even so, its stock price declined by 50 percent between October
and November.
The Massachusetts Turnpike Authority faced a $467 million bill in No-
vember 2008 from three interest rate swap contracts it had entered into with
UBS, Lehman Brothers, and JPMorgan. The Pennsylvania State Employees
Retirement System’s pension fund suffered from a similar problem, but the
amount it had to pay under a “portable Alpha” trading program reached $2.5
billion. The portable Alpha trading program sought to obtain returns higher
than the market could provide. This had been a successful strategy while the
market was rising from 2003 to 2006, but was not successful when the mar-
ket turned down. It was estimated that a total of $75 billion was invested in
portable Alpha programs, including other state pension funds.
The sums held in money market funds hit record levels in the last week
of November, as investors fled to these now-government-guaranteed invest-
ments. The Dow and the S&P 500 rose again on November 26 and 28, 2008,
extending the consecutive increases to five days in a row, during which Citi-
group’s share price doubled. However, a report was published indicating an
accelerated decline in consumer spending, as well as business investment.
Retail sales fell in November by 5.5 percent over the previous year, the worst
such decline in almost forty years. Online sales were at about the same level
as the previous year, not a heartening statistic considering that it was still a
developing market.
Equities lost $10.4 trillion in market value between the high in October
2007 to the low in November 2008, comprising about 54 percent of total mar-
ket value. The stock market dropped sharply on December 1, 2008, the first
workday after Thanksgiving. The Dow fell by 679.95 points on that day, but
recovered 270 points the next day, closing at 8419.09. Market uncertainty was
amplified by predictions that Goldman Sachs would report a loss of $2 billion
for its quarter ending November 28, 2008. The actual loss was $2.12 billion, the
first loss for Goldman Sachs since it went public in 1999. However, its stock
price rose 14 percent after that loss was announced. Then, several governors
warned of large shortfalls in state budgets. Funding sources for municipali-
ties were drying up. The Port Authority of New York and New Jersey did not
receive a single bid in a $300 million note offering. Another blow came when

Pilgrim’s Pride, a large chicken producer, filed for bankruptcy protection on

December 2, 2008.
In November, sales of existing homes fell by 8.6 percent over the previous
month. New home sales shrank by 2.9 percent. The median sales price of an
existing home was $220,400, 11.5 percent lower than the previous year. The
inventory of unsold homes dipped slightly in November, but there was still
more than an eleven-month supply. It was estimated that 45 percent of existing
home sales were the result of foreclosures. The number of delinquent mortgages
was expected to double by the end of 2009. A survey found that 10 percent of
U.S. households with mortgages were delinquent or in foreclosure.
The yield on the ten-year Treasury note fell to 2.719 percent in the beginning
of December 2008, the lowest yield on those securities in more than thirty years.
The Federal Housing Administration (FHA) was reported to have experienced
a 39 percent decline in its capital cushion for mortgages that it was insuring in
December 2008. The FHA’s share of new insured mortgages increased to 26
percent in the third quarter of 2008, up from 3 percent in 2007. The FHA was
practically the only insurer available for low-income individuals. Its up-front
premiums charged to borrowers rose in October to 1.75 percent, up from 1.5
percent. Borrowers were also charged annual premiums that ranged from 0.5
percent to 0.55 percent of their loan balance.
The Harvard endowment lost 22 percent of its value in the four-month period
between July and November 2008. In all, the school’s endowment lost over
$8 billion, which was more than the endowments of all but a few universities.
Harvard warned that the loss could be even larger after some of its hard-to-
value investments were priced. Nevertheless, the six top Harvard endowment
fund managers were given bonuses of $26.8 million for their performance in
the year ending June 30, 2008.
Other schools faced losses. The Yale and Stanford endowments lost more
than 25 percent of their value between July and December 2008. For Yale,
this meant a loss of almost $6 billion, and it forecast a $100 million shortfall
in revenues for 2009. The Massachusetts Institute of Technology reported
that its endowment had contracted by more than 20 percent, and the Princeton
endowment shrank by 23 percent. College endowments lost a total of $94.5
billion in 2008. The Nobel Prize endowment fell by 20 percent. By contrast,
the Russian stock market had lost 70 percent during the year.
Jobless claims were at a twenty-six-year high as December 2008 began. The
unemployment rate rose to 6.7 percent at the end of November, the highest in
fifteen years, after the economy lost 533,000 jobs. Some 1.3 million jobs had
been lost since September 2008. The Fed’s Beige Book published on December
3, 2008, disclosed that economic activity was weakening in all Fed districts
and across broad sectors of the economy.
Concerns over the economy heightened after the National Bureau of
Economic Research announced that the country had been in recession since
December 2007. That prestigious group used a definition of recession that

focused on whether there was a significant widespread decline in the economy

lasting more than a few months. Generally, economists define a recession as
two quarters in a row of reduced growth, which had not yet occurred. However,
no matter how it was defined, the consensus was that the economy was in the
midst of a very serious recession.
The United States Department of Agriculture (USDA) became another
lender of last resort. Consumers exiting the cities obtained loans through a
program created in 1991 that was designed to encourage homeownership in
rural areas. A 2 percent fee charged by the USDA for such loans could be
included in the loan.
Treasury Secretary Paulson considered, in the first week of December,
whether to seek authorization from Congress to draw down the funds remain-
ing in the $700 billion TARP bailout. However, he encountered resistance
from members of Congress who questioned the efficacy of the program and
entertained competing requests for funds from state governments and auto-
makers. Paulson also considered the creation of a program to provide banks
with incentives to offer new mortgages at rates as low as 4.5 percent. His
announcement of that proposal caused a jump in the stock market. The Dow
rose by 172.60 points, but dropped by 215.45 points on December 4, 2008.
The market regained that loss and even picked up a little on the following
day, and it rose again on December 8, 2008, with the Dow reaching 8934.18.
Oil prices fell to $40.81 per barrel on December 5, 2008, and the thirty-year
conventional mortgage rate fell to 5.53 percent.
President-elect Obama warned that things were going to get worse before
they got better. He was right. On December 8, 2008, federal regulators opened
a $41.5 billion lending facility that Congress had authorized in September 2008
for “corporate credit unions,” wholesale credit unions that provided financing
to retail credit unions. Still, five of these credit unions failed over the next
two years and the government was forced to issue a $30 billion guarantee in
September 2010 to protect the surviviors.
Credit Suisse announced in December the elimination of 5,300 jobs, about
11 percent of its workforce. It had lost $2.48 billion over the previous two
months. JPMorgan Chase laid off 4,000 employees at Washington Mutual
that month. Together these cuts brought the number of jobs lost at financial
services firms since October 2008 to more than 90,000, including 52,000 jobs
at Citigroup. Merger volume on Wall Street was down 28 percent in December
2008. Much of the structured financing that had driven profits for investment
banking firms for the previous few years had dried up. However, the corporate
debt market showed improvement. Some $5 billion in investment-grade debt
offerings were brought to market in the first week of December 2008.
Bank of America received some negative publicity because of a sit-in pro-
test by union employees of a door and window factory in Chicago that was
closed because the bank had stopped its financing. Critics claimed that, because
Bank of America had received large sums in the government bailout, it should

make loans to companies like the one in Chicago, even if they were no longer
creditworthy. The City of Chicago threatened to cut off its substantial business
with the Bank of America as a result of that protest, which became national
news after Illinois’s governor, Rod R. Blagojevich, asked state agencies to
sever their business relationships with the bank as well. However, that story
was superseded the next day when Blagojevich was arrested for trying to sell
the Senate seat vacated by Obama after being elected president.
The Automakers Fail
Problems in Motor City
The automobile industry had long been at the center of America’s industrial
might, but it had been losing market share to foreign manufacturers since
the 1960s. Chrysler nearly failed in 1979, and it appealed to Congress for a
bailout in the form of loan guarantees. Lee Iacocca, who had lost his job at
Ford, agreed to lead a rescue effort, at a salary of $1. He sought $1.5 billion
in guarantees from Congress and $2 billion in concessions from the Chrysler
unions, dealers, and creditors. The bailout legislation set off a storm of con-
troversy, but Congress eventually acceded to this request and created a Loan
Guaranty Board authorized to guarantee up to $1.5 billion in loans with all
of Chrysler’s assets used as collateral. The banks also helped by exchanging
$1.3 billion in debt for Chrysler preferred stock.
Chrysler recovered and became profitable in 1982 and subsequently was
acquired by Daimler-Benz in 1998 for $36 billion. However, the merged entity,
called DaimlerChrysler, was not successful. In 2007 an 80 percent stake in the
old Chrysler was sold to a private equity group, Cerberus Capital Management,
and renamed Chrysler. The deal with Cerberus was somewhat unusual in that
it agreed to invest $7.4 billion in Chrysler but paid Daimler only $1.35 bil-
lion. Daimler also agreed to hold a large portion of Chrysler’s debt. Corporate
raider Kirk Kerkorian had made an offer of $4.5 billion for Chrysler through
his private equity firm, Tracinda, but was rebuffed in favor of the Cerberus bid.
Cerberus raised $12 billion from several large investors, including Citigroup,
to acquire its stake in Chrysler, as well as a 51 percent ownership interest in
GMAC Financial Services, the financing arm of General Motors.
Chrysler reported a loss of $2.9 billion in a two-month period in 2007, and
its losses continued to mount as the subprime crisis deepened. On October 24,
2008, it announced the elimination of 5,000 jobs, bringing the total to 30,000.
Warfare then broke out between Daimler and Cerberus Capital, with the latter
claiming that Daimler had mismanaged the company while the closing was
pending.
Cerberus’s investment in GMAC also quickly soured as the financial services
firm began to experience large subprime loan losses in March 2007. It reported
a $2.52 billion loss for the third quarter of 2008. GMAC restructured $14

billion in debt held by Residential Capital Corporation (ResCap), an affiliate

that had lost $9.1 billion in the previous two years from subprime mortgages.
Investors in the mortgage securities that ResCap issued were required to take
reductions in their outstanding principal and to extend maturities. That effort
bought some time, but ResCap securities soon had more troubles. GMAC
refinanced its ResCap mortgage unit through a transaction valued at $60 bil-
lion and was able to arrange a debt-for-equity swap covering $21.2 billion of
its debt. However, about 40 percent of GMAC bondholders refused to agree
to the arrangement. An even larger percentage refused a debt–equity swap
for ResCap notes. Standard & Poor’s then cut the GMAC credit rating to
“selective default.”
The Cerberus investments in GMAC and Chrysler were in even more seri-
ous difficulty in late 2008 as those two companies floundered in the face of
sharply reduced demand for automobiles and the burgeoning credit problems
associated with defaulting automobile loans. Chrysler then sought a govern-
ment bailout of $7 billion in short-term funding but received only $4 billion in
December 2008, despite being desperately needed, as Chrysler’s automobile
sales dropped by 53 percent in December 2008.
GMAC was trying to convert itself into a national bank in December in
order to obtain a federal bailout, and that conversion was approved by the Fed
in a 4-to-1 vote. Thereafter, on December 29, 2008, the Treasury Department
purchased a $5 billion interest in GMAC and lent General Motors $1 billon
to finance the reorganization of GMAC into a bank holding company. For its
$5 billion the government was given 8 percent senior preferred equity.
That bailout resulted in the reduction of Cerberus’s interest in GMAC from
51 percent to 14.9 percent in voting shares and one-third of total equity. This
reduction was necessary in order for Cerberus to avoid being treated as a bank
holding company, which would restrict its operations. Cerberus was also sub-
ordinated to the claims of the federal government for its bailout payments. On
December 23, 2008, it suspended withdrawals by its investors.
General Motors and Ford
The government bailout allowed GMAC to assist General Motors (GM) by

providing 0 percent financing on some models and reducing interest rates
on other models as a part of a year-end sales program. GMAC was also able
to begin a nationwide advertising program offering government-guaranteed
certificates of deposits as a way of raising funds at a very favorable interest
rate. It was not enough to save GM, which lost $10.46 billion in 2005; $2 bil-
lion in 2006; $38.7 billion in 2007; and $30.9 billion in 2008. Despite all the
problems at GM, its CEO, Rick Wagoner, was given a 33 percent pay increase
for the work he did in 2007.
GM’s rival, the Ford Motor Company, lost $5 billion in 2002, returned to
profitability in 2003, and posted a $2 billion profit in 2005. However, that

profit was largely due to gains from financial services. The Ford automotive
operations lost $3.9 billion in 2005, a loss that was mostly attributable to its
North American operations. The faltering Ford was under fire in the press
after disclosure that one of its executives, Mark Fields, was allowed to com-
mute between his home in Florida and his job in Detroit on the company jet
at a cost of more than $200,000 per quarter. He then gave up the jet. The
operations that executive managed lost $3.3 billion in the first nine months
of 2006.
Ford tried to use a more balanced compensation arrangement for its new
CEO, Alan Mulally, who was recruited from Boeing. However, it was not
exactly a minimum wage. Mulally was given $2 million in salary, an $18.5
million signing bonus and, as compensation for loss of options at his old em-
ployer, 600,000 shares of restricted stock and 4 million stock options. That
hire came too late to prevent the record $12.7 billion loss by Ford in 2006,
$5.8 billion of which came in the fourth quarter. Pundits computed that year’s
loss as occurring at a rate of about $240,000 a minute.
Ford’s annual loss declined to $2.7 billion in 2007, but then exploded to
$14.7 billion in 2008. Kirk Kerkorian had accumulated Ford stock, but he
reduced his $1 billion investment in the week of October 20, 2008, because
of concerns about its viability. Those concerns were not without basis. Hav-
ing lost its place as the number two automaker in the United States to Toyota,
Ford fell to number three for the first time since the 1930s.
Although much play was given in the press to executive compensation at
GM and Ford, it was the labor unions that milked the U.S. automakers com-
pletely dry. Members of the United Auto Workers (UAW) union were paid $71
an hour, compared with $49 per hour paid to nonunion automobile employees
at auto plants owned by foreign countries located in the United States. GM
spent $4.8 billion on health care for employees in 2008, which added $1,500
to the cost of every car that it produced. The health-care liabilities of General
Motors were twice its market capitalization.
The UAW carried out a strike at GM in September 2007, but shortly after-
ward, the two sides reached a new labor agreement in which the UAW agreed
to relieve GM of its long-term retiree health-care benefits in exchange for
GM’s contribution of $30 billion to a new health-care trust to be managed by
the union. Those obligations were thus moved off GM’s books. However, that
$30 billion was some $20 billion less than the value of unfunded benefits due
workers. The union intended to make up the shortfall from its investment of
the trust funds. The stock market crash in 2008 forestalled that plan.
Chrysler reached an agreement with the UAW in October 2007 that was
similar to the one reached with GM. Motor vehicle sales were then at a twenty-
five-year low, and many dealerships closed. Overall automobile sales fell by
32 percent in October 2008. GM sales fell by 45 percent compared with the
previous year. Automobile sales in United States dropped further, by 36.7
percent in November and 35 percent in December.

The Motor City Bailout Begins
GM and Ford spent $14.6 billion of their available cash in the third quarter
of 2008. By then, the automakers had exhausted their credit in the financial
markets. They had raised some $56 billion in loans over the previous three
years, and those loans were still outstanding. A further $50 billion or so of
loans had been extended to their affiliates, backed by auto leases and car
loans. Ford was in better shape than the other two big automakers because it
had drawn down a $23.6 billion line of credit in November 2006, providing it
with a large cash cushion. However, GM announced that it might run out of
cash before year-end unless it was given a government rescue. It also launched
talks with Chrysler about a possible merger. Both companies requested gov-
ernment assistance totaling $25 billion, but the Treasury Department turned
them down. President-elect Obama then asked President Bush to help, and
he considered providing the funds as loans under a program to develop fuel-
efficient vehicles.
GM became increasingly desperate in late November 2008 and increased
its demands for assistance. Among other things, GM sought tax incentives to
help spur car purchases. CEOs of the big three automakers testified before
Congress in November 19, 2008, and received some sympathy until it became
clear that they had no plans for restructuring or cutting labor and other costs,
though they were much higher than their competitors. Two of the three made
things worse by declining to agree to take a salary of $1, as Iacocca had done
when Chrysler was bailed out in 1979. Their credibility was undermined further
when it became clear that the auto executives had flown to Washington, DC,
on their private corporate jets. Embarrassed, GM announced a few days later
that it would give up two of its leased jets, leaving only three for the execu-
tives. The firm also closed its air transportation unit, which had forty-nine
employees on the payroll. It then asked the Federal Aviation Administration
(FAA) to block anyone from tracking its remaining jets in order to avoid
further embarrassment.
The Democratic leadership invited the CEOs to come back to Congress
when they had a plan for reorganization and a return to profitability, which
they did in December. Collectively they sought a $34 billion bailout. GM said
it needed $4 billion immediately in order to survive until the end of the year.
In total, GM requested $18 billion in loans, an increase of $6 billion over the
amount sought two weeks earlier. Chrysler sought $7 billion immediately and
requested an additional $6 billion from the Energy Department for the develop-
ment of fuel-efficient vehicles. Ford asked for a $9 billion line of credit and
an additional $5 billion from the Energy Department.
As an alternative to an unsupervised bailout with taxpayer funds, Congress
considered a “prearranged” bankruptcy for the automakers that would include
a settlement with their creditors before filing so that the automakers could exit
Chapter 11 quickly. The automakers warned, however, that consumers might

not want to buy cars from a company in bankruptcy because of concerns over
warranties. Consumers were, in any event, not buying cars. The debate con-
tinued over whether the automakers should reorganize under the bankruptcy
laws, but the automakers continued to resist. One suggested model for their
restructuring was based on the reorganization of the railroads in the Northeast
in the 1970s, which led to the formation of Conrail. That effort was success-
ful, resulting in the closure of nonprofitable lines and halving of the bloated
workforce. The operation even turned a profit before being sold to private
companies.
The House approved a short-term cash infusion to save the automakers.
However, Republicans in the Senate balked because the UAW refused to reduce
wages of its members to the same level as those of workers at nonunion plants
in the United States owned by foreign automobile manufacturers. The union
stated that it would agree to some adjustments in 2011, when its contracts were
up, but not before then. President Bush then intervened and on December 19,
2008, directed the Treasury Department to use TARP funds for a quick bailout
of the automakers. The Bush administration agreed to lend $13.4 billion to GM
and $4 billion to Chrysler. In the meantime, the controversy over the bailout
caused Ford to reconsider its position, and it withdrew its bailout request. Al-
though Ford posted a $5.9 billion loss in the fourth quarter of 2008, as of April
6, 2009, it paid off $9 billion in debt, cutting its debt load by 28 percent.
The bailout loans to GM and Chrysler were conditioned upon obtaining
concessions from employees, suppliers, dealers, and creditors. The UAW
agreed to a 20 percent cut in hourly compensation and later agreed to bring
its hourly wages in line with the non-union plants of foreign car manufactur-
ers. Although the UAW membership shrank from 1.5 million in the 1970s to
431,000 in 2008, their political contributions assured that they would remain
a powerful political force. The union had funding of $1.2 billion and collected
annual dues totaling $161 million.
The Bush administration wanted the automobile companies to replace
two-thirds of their debt with stock and to use stock to fund retiree health-care
programs. It reiterated the need for the UAW to make the wages of its mem-
bers competitive with those at foreign companies. The union agreed to some
other concessions, including allowing the automakers to delay payments to
the health-care buyout arrangement and suspending a “Job Bank” program
that paid workers even after they were laid off.
On February 10, 2009, GM announced the elimination of 10,000 salaried
jobs, in an apparent effort to set an example for reducing union wages. Chrysler
bought out about 25 percent of its white-collar workers, a reduction of about
5,000 employees, and it shut a Delaware plant. One Chrysler executive felt the
pain of reduced compensation. Jim Press, Chrysler’s deputy CEO, defaulted
on a $600,00 credit union loan and owed back taxes of over $1 million.
Chrysler tried to sell 30 percent of itself to Fiat in January 2009, with the
option of increasing that stake to 55 percent. However, Fiat conditioned its

investment on an additional $3 billion injection from the federal government.

But that month Chrysler’s sales were down 55 percent and GM’s sales fell by
49 percent compared with the previous year. The two firms reported that they
would need at least $21.6 billion to avoid bankruptcy. In exchange, GM offered
to cut 47,000 jobs, to close five factories, and to end the production of some
car lines, including Hummer and Saturn. GM’s downward spiral continued
with the bankruptcy of Saab on February 20, 2009.
The Obama administration initially took a tough stance on bailing out the
automakers. It sent a team to the automakers to review their restructuring plans,
which had to be completed by March 31, 2009 in order to obtain additional
bailout funds. That team did not like what it saw and ordered GM CEO Rich
Wagoner to resign, which he did on March 29, 2009. Wagoner had led GM
since 2000. During his tenure, the automaker lost 10 percent of its market
share, and the price of the company’s stock dropped from $80 per share to
less than $4. Wagoner had won a rather dramatic battle with Kerkorian, who,
in 2001, purchased about 10 percent of GM’s stock in order to force it to enter
into merger negotiations with Nissan Motor Company and Renault. It was a
Pyrrhic victory that prevented the restructuring desperately needed at GM.
The Obama administration placed a great deal of pressure on GM and
Chrysler’s creditors, demanding that they exchange much of their debt for
equity positions. The administration wanted Chrysler’s creditors to give up 85
percent of their $7 billion in outstanding debt. The government also considered
dividing the assets of GM and Chrysler into good and bad assets, after which
the two companies would declare bankruptcy and rid themselves of the worst
of their problems. “Good” assets for GM included Chevrolet, Buick, GMC,
and Cadillac, while “bad” ones comprised Saturn, Pontiac, and Hummer.
The former would go to a “new” GM to be owned by creditors and the UAW,
and the latter would be left in an “old” GM for the benefit of its retirees. The
government also pushed Chrysler to merge with Fiat.
GM offered to make the federal government a majority stockholder in April
2009 in exchange for a loan of an additional $11.6 billion, which would bring
the total bailout of the firm to more than $25 billion. Under this proposal, the
UAW would be given a 39 percent ownership interest in lieu of cash payments
to its retiree heath-care fund. GM debt holders resisted another proposal that
would have them swap $27 billion in secured loans for a 10 percent owner-
ship interest in GM. The company also sought an agreement by the unions to
cut labor costs by $1 billion and to reduce its $20 billion obligation for UAW
health-care costs.
As 2009 began, GMAC had converted to bank status in order to be able to
issue government guaranteed debt. However, GMAC failed to obtain approval
for that funding and still sought it in April 2009. In May the Treasury Depart-
ment announced approval of a bailout of as much as $14 billion for GMAC.
In May 2009, GM closed 1,100 dealerships, about half the total number to
be closed. The government pumped in another $4 billion to keep GM afloat on

May 22, 2009, but the company was forced to file for bankruptcy on June 1,
2009, as it continued to experience liquidity problems. This was the second-
largest industrial bankruptcy on record, just behind WorldCom. After its
bankruptcy filing, GM was dropped from the Dow Jones Industrial Average.
GM reported that it had $82 billion in assets and $172 billion in debt. It had
not been profitable since 2004.
GM’s bankruptcy was expected to cost taxpayers $30 billion, in addition
to the $20 billion already handed out to that company. In exchange, the gov-
ernment was given a 60 percent equity stake in the company. Bondholders
were to be given a 10 percent stake, the UAW health-care fund 17.5 percent,
and the Canadian government 12.5 percent. GM announced that, as a part of
its reorganization, it would cut an additional 20,000 jobs and close seventeen
factories and parts centers. This would shrink its workforce by 90 percent
from the levels in the 1970s.
Meanwhile, Fiat tried to bring in Opel to form a three-way alliance with
Chrysler. That effort was interrupted by President Obama, who announced on
April 30, 2009, that Chrysler was going into bankruptcy after creditors refused
to settle their $6.9 billion in debt claims for $2 billion. The president attacked
those creditors publicly, calling them “speculators” and stating: “I don’t stand
with those who held out when everyone else was making sacrifices.”15 The
creditors caved in the face of those remarks and agreed to accept the $2 billion
in cash. It was also disclosed that the government had pushed Chrysler to make
the deal, despite concerns by Chrysler executives over its viability.
Chrysler announced on May 14, 2009, the closure of 789 dealerships in the
United States, about 25 percent. On June 1, 2009, a bankruptcy judge approved
the sale of Chrysler’s assets to Fiat. A federal appeals court then approved the
transaction over the objection of a group of creditors, and the Supreme Court
declined to review that decision. The petition for bankruptcy was followed by
an announcement that Chrysler’s sales had fallen by 48 percent in April 2009.
Industrywide, the decline was 34 percent. Chrysler Financial, the lending unit
of Chrysler, was bailed out in January 2009 through an emergency $1.5 billion
loan from the Treasury Department.
Auto parts makers also suffered from the downturn in auto sales and sought
access to TARP bailout funds. Some of those firms faced bankruptcy in 2009,
including Visteon, a principal supplier to Ford, and Lear. The Obama admin-
istration announced in March 2009 that it would provide $5 billion to assist
auto part suppliers through payments to the automakers.
GM emerged from bankruptcy in July, only forty days after it filed. It had
originally planned to sell its Opel and Vauxhall operations but backed off
that plan before changing its mind again and announcing that it would sell 55
percent of Opel to Magna International, but GM later withdrew the proposal.
A deal to sell Saturn to Penske Automotive Group fell through in September
2009 because of manufacturing concerns. Car sales were boosted by a provision
in the stimulus package called the Car Allowance Rebate System (CARS) but

more commonly called “cash for clunkers.” Under this program, consumers
trading in a gas guzzler for a more fuel-efficient vehicle received a government
voucher, valued at as much as $4,500, on their trade-in. The program proved
so popular that the $1 billion allocated to it was exhausted in the first week.
Congress quickly approved another $2 billion for the program. Toyota was
the leading beneficiary of this giveaway, but the program helped auto sales
overall. In August auto sales were the highest in more than a year.
The Obama administration appointed Steven Rattner as its “car czar”
to oversee the government’s investments in the automakers. However, he
resigned on July 13, 2009, after only a few months on the job because of an
investigation involving his activities while he was a partner in the Quadrangle
Group, a private equity firm. The investigation, under New York attorney gen-
eral Andrew Cuomo, concerned payments by private equity groups, such as
Quadrangle and Carlyle, for the purpose of obtaining New York government
pension fund monies for investment, a service for which they were paid large
fees. Quadrangle later agreed to pay $7 million to the New York State pension
fund and $5 million to settle SEC charges over those payments. In a statement
accompanying the settlement Quadrangle disavowed the conduct engaged
in by Rattner. The SEC subsequently adopted a rule prohibiting investment
advisers managing funds of public pensions from contributing to politicians
with oversight responsibility for the funds. The SEC had previously adopted
such a rule for state and municipal bond underwritings.
Foreign manufacturers also suffered during this global crisis. At Honda,
sales were down 31.6 percent for the first nine months of 2008, and Nissan’s
were down 42.2 percent. Toyota sales were down 33.9 percent, while its profits
in its fiscal second quarter fell by 69 percent. The company issued a profit
warning on December 22, 2008, advising that it expected to report an operating
loss for the year of $1.7 billion—the first annual loss for the company since
1938. Although Toyota’s sales fell, it still surpassed GM in the number of cars
produced in 2008, making Toyota the world’s largest car manufacturer.
France provided $8.4 billion to Renault and PSA Peugeot Citroën in Febru-
ary 2009 in order to prop up those companies. France’s $3.9 billion low-interest
loans to Renault was conditioned on an agreement that the automaker would
not close any factories in France or engage in mass layoffs there. Peugeot
dismissed its CEO, Christian Streiff, at about the same time that Wagoner lost
his post at GM. Peugeot lost $455 million in 2008, and the firm’s stock price
fell by 70 percent over the previous year. Streiff had displeased the French
government by announcing a large number of layoffs in France and by import-
ing cars into France made in the Czech Republic.
Porsche Automobile Holdings reported enormous profits, $10.9 billion.
However, most of those earnings were from a transaction that allowed it to
effectively corner the shares of Volkswagen, trapping short traders who had
to buy Volkswagen shares at any cost. The result was a huge spike in the price
of Volkswagen shares held by Porsche. Porsche had, at one point, acquired a

51 percent ownership stake in Volkswagen and options for 20 percent more.

Much litigation followed that affair. It also turned sour for Porsche, which an-
nounced in July 2009 that it would take a $7 billion charge on its Volkswagen
holdings and was in talks to be taken over by Volkswagen. The CEO and CFO
of Porsche were under investigation for insider trading. The Porsche losses
did not deter the hedge funds that were shorting Volkswagen.
The Madoff Fraud and Other Problems
Fraud Continues
The SEC brought a record number of insider-trading cases in 2008, while it

appeared to ignore the subprime crisis destroying or maiming the nation’s
largest broker-dealers. Matthew C. Devlin pleaded guilty to charges that he
was running a $5 million insider-trading operation from information stolen
from his wife, a partner at Brunswick Group, a communications firm. Devlin
referred to his wife in e-mail messages as his “golden goose.” Four individuals
pleaded guilty in that case, including a broker at Lehman Brothers.
Charges were brought against six defendants in the “squawk box” case,
in which traders at Merrill Lynch, Lehman Brothers Holdings, Citigroup’s
Smith Barney unit, and Bank of America provided telephone access to their
internal speaker systems to day traders at A.B. Watley, providing the Watley
traders advance notice of large trades by customers of the brokers, which
were announced on the squawk boxes. That advance knowledge allowed the
A.B. Watley traders to trade in front of those orders and profit. After a first
trial that resulted in a hung jury, the defendants were convicted after a retrial.
Merrill Lynch settled squawk box charges brought against it by the SEC in
this matter for $7 million in March 2009.
Mark Cuban, the owner of the Dallas Mavericks professional basketball
team, was charged with insider trading. Cuban had became a billionaire after
he sold Broadcast.com to Yahoo! for $5.7 billion. Cuban ran into trouble with
the SEC after he was told about a private investment in public equity (PIPE)
transaction in the stock of another company, Mamma.com, that would be sold
at a discount to the existing market price and would cause a loss in Cuban’s
existing stock holdings in that company. After receiving that information,
Cuban sold all of the stock in Mamma.com, avoiding losses of $750,000. A
federal judge later dismissed the case, but that decision was reversed on ap-
peal. However, Louis W. Zehil, a partner in the New York office of a large law
firm, pleaded guilty to charges that he illegally sold PIPE securities he had
bought for a profit of $17 million. The shares were restricted and were sold
without SEC registration.
JPMorgan Chase was under investigation by regulators in 2008 after an
academic study found unusual trading activity by the bank in the stocks of
companies involved in acquisitions for which JPMorgan investment bankers

were acting as advisers. One such company was Rural Cellular Corporation, a
small Minnesota company later acquired by Verizon Wireless for a substantial
premium. JPMorgan asserted that it was only a coincidence and that the pur-
chases were made on behalf of clients. The Wall Street Journal then conducted
a study of transactions by other investment banking firms and found numerous
instances of similar transactions in the stock of investment banking clients.
Merrill Lynch was also under investigation for front-running trades (trading in
advance of a customer order) placed by a mutual fund, Fidelity Investments.
Jeffrey A. Royer, an FBI agent, was convicted of insider trading and sen-
tenced to six years in prison. He had supplied negative information about
companies that another defendant used to short sell stock. That information,
disseminated on the Internet by the defendant on his blog, succeeded in de-
pressing the price of the companies’ stock.
Thomas Petters, the owner and founder of Petters Company, a private in-
vestment firm, was arrested in October 2008 for fraud, in which losses were
estimated at as much as $2 billion. He was later convicted by a jury of running
a Ponzi scheme. Norman Hsu, a fundraiser for Hillary Clinton’s presidential
campaign, was indicted after it was discovered that he had been running a Ponzi
scheme that raised $20 million from investors by promising extraordinary
profits through short-term financing extended to other companies. Hsu pleaded
guilty to fraud charges. He was also separately convicted by a jury on charges
of campaign law violations and sentenced to twenty-four years in prison.
Joseph Shereshevsky, the operator of WexTrust Capital, a hedge fund used
to solicit investments from wealthy Orthodox Jews in the Norfolk, Virginia,
area, was arrested in August 2008 and charged with running a Ponzi scheme,
in which investors lost more than $100 million. His partner Steven Byers
pleaded guilty to fraud charges, but Shereshevsky denied any wrongdoing.
The KL Group, another hedge fund, defrauded wealthy Palm Beach investors
of an estimated $200 million. Proving that there is no limit to the greed of
fraudsters, Gordon Grigg and his firm, ProTrust Management, were charged
by the SEC with defrauding investors by telling them that he was investing in
TARP through government-guaranteed commercial paper and bank debt. TARP
had no such investments available. Grigg pleaded guilty to criminal charges
related to this fraud. Kenneth Starr, an investment adviser to entertainment
stars, pleaded guilty to defrauding investors of $60 million in a Ponzi scheme.
Among his clients were Al Pacino, Martin Scorsese, Sylvester Stallone, and
Wesley Snipes.
The Madoff Fraud
These frauds turned out to be small potatoes. Bernard L. Madoff, a well-known

figure in the securities business, was arrested on December 11, 2008, after
he confessed that he had been running a giant Ponzi scheme involving some
$50 billion that he was managing for wealthy investors. That figure grew after

investigators determined that Madoff had been reporting to investors that he

held $64.8 billion in their accounts. This turned out to be the largest invest-
ment fraud in history. Actual out-of-pocket losses (minus claimed false profits)
were estimated in December 2009 at $19.4 billion, an increase over the $6
billion in original estimates. The Securities Investor Protection Corporation
(SIPC), the government sponsored broker-dealer insurer, agreed to pay inves-
tors $534 million to cover their losses, with maximum coverage per account to
be $500,000. The receiver appointed to liquidate the Madoff fund recovered
about $1.5 billion, but the greatest relief of all was new IRS rules allowing
the Madoff investors to deduct their losses, including fictitious gains reported
to them by Madoff, on their tax returns by carrying them back for five years
and forward for twenty years.
Madoff had helped build, and was a former chairman of, NASDAQ and
had served on the board of governors of the National Association of Securi-
ties Dealers (NASD) (now FINRA), the self-regulatory body of the securities
industry. He also served on an SEC advisory committee. Several of Madoff’s
clients were recruited at the Palm Beach Country Club in Florida. Also among
Madoff’s victims were a number of Jewish charities, including one sponsored
by Elie Wiesel, a Nobel laureate. Tufts University lost $20 million; Yeshiva
University lost more than $100 million, and Bard College lost $3 million.
Mortimer Zuckerman lost millions of dollars. Jeffrey Katzenberg, the head
of DreamWorks Animation, and Steven Spielberg’s Wunderkinder charity
were hit as well. The actors Kevin Bacon and his wife, Kyra Sedgwick, were
Madoff investors and lost money.
The Madoff scandal exposed another questionable aspect of hedge fund
investments, the money finders, or “placement agents,” that is, individuals
with family, social, or other connections with wealthy investors. The money
finders are paid a fee, usually a percentage of the money they refer to the
hedge fund, for their referral service. They are supposed to use due diligence
before making such recommendations, but their relationship with the hedge
fund manager is often either social or fee-based, both of which discourage
inquiry, which appeared to be the case for the Madoff scandal.
Fund-of-funds, which invest in other hedge funds, were supposed to be
receiving fees for finding and vetting the best hedge fund managers, but those
managers had done little due diligence in Madoff’s case. Some money manag-
ers claiming expertise were simply placing money with Madoff and claiming
success from his supposed returns. Bank regulatory authorities in Luxembourg
accused UBS of a “serious failure” in due diligence while acting as custodian
of a $1.4 billion hedge fund that sent money to Madoff. UBS was ordered to
pay compensation to those investors.16 A number of other fund-of-funds had
placed large amounts of their clients’ funds with Madoff, including Union
Bancaire Privée, which raised some $1.25 billion for Madoff.
Ascott Partners, a hedge fund headed by Ezra Merkin, the chairman of
GMAC, lost $1.8 billion, including $3 million that it had invested for the

New York Law School. After his judgment was questioned with respect to his
dealings with Madoff, Merkin resigned as chairman of GMAC, which was
in the midst of a government rescue. Merkin was sued by New York attorney
general Cuomo, who charged that Merkin had misled investors into thinking
that he was actively managing their investments, when in fact he had simply
given the funds to Madoff and collected more than $470 million in fees. The
Fairfield Greenwich Group was the largest feeder fund for Madoff, raising
over $7.5 billion. Massachusetts’s authorities charged that hedge fund with
civil fraud because it failed to conduct the due diligence that it promised its
investors. It was further charged that Fairfield ignored numerous red flags
warning that Madoff was involved in improper activity.
Some other sophisticated institutions also sustained losses. Kingate Manage-
ment lost $3.5 billion; Tremont Group Holdings, a hedge fund owned by Mas-
sachusetts Mutual Life Insurance Company, lost $3.3 billion; Banco Santander,
$3.1 billion; HSBC Holdings, $1 billion; the Man Group, $360 million; the
Royal Bank of Scotland, $360 million; and Nomura Holdings, $302 million.
The government of Austria was forced to take over Bank Medici, which lost
more than $2 billion in client funds through investments with Madoff.
One unlucky investor, Martin Rosenman, gave Madoff $10 million only
six days before the fraud was exposed. Worse yet, Madoff collected $250 mil-
lion from his good friend Carl Shapiro just ten days before being arrested, in
addition to $150 million that he had given Madoff earlier. Kenneth Langone,
a former director of the New York Stock Exchange, declined a request from
Madoff to make an investment. JPMorgan Chase withdrew $250 million of
its funds from the Madoff program in the fall of 2008 because of its lack of
transparency and concern over its exposure to hedge funds. However, some
former senior Merrill Lynch executives, including Daniel Tully and David
Komansky, suffered losses from their investments with Madoff.
Madoff was released on bail after his arrest, but was confined to his New
York residence after a shoving match and near-riot broke out among reporters
when he decided to take a stroll. On January 5, 2009, the government peti-
tioned a federal magistrate to revoke his bail after it was discovered that he
had mailed some $1 million worth of jewelry to relatives and friends, which
violated an SEC injunction freezing his assets. The government also reported
that it found $173 million in signed checks made out to family and friends in
Madoff’s offices. However, the magistrate refused to approve this petition.
It was later discovered that Madoff’s wife, Ruth, had withdrawn $15.5 mil-
lion from their bank accounts just before his arrest. Vanity Fair featured exposés
on her and her family complete with a decades-old photograph of her sunbath-
ing topless but otherwise a bit short of proof that she had participated in the
fraud. She agreed to the U.S. attorney’s request that she relinquish any claims
to assets of the Madoff family in excess of $2.5 million, which were assets
unrelated to the fraud, forgoing claims against more than $80 million in other
assets. She also had to disclose any purchases that she made in excess of $100.

The bankruptcy trustee then filed a $45 million lawsuit against her. The New
York Times published a profile of Madoff on January 25, 2009, which quoted
a criminal profiler who compared Madoff to serial killers like Ted Bundy.17 He
was treated like one. Madoff pleaded guilty to eleven felony counts on March
12, 2009. Although he professed remorse for his crimes, Madoff refused to
implicate others in his fraud. A federal judge immediately revoked Madoff’s
bail and sent him to prison to await sentencing. He did not have to wait long.
On June 29, 2009, Madoff was sentenced to 150 years in prison. Fortunately
for Madoff, Americans never took to the guillotine. Otherwise, his investors,
not without some cause, would have demanded its use.
Shortly after his guilty plea, Madoff’s accountant, David G. Friehling, was
arrested. He was the auditor for Madoff’s advisory service, but apparently he
had certified the accuracy of the Madoff accounts without actually auditing
them. Another Madoff associate, Frank DiPascali, pleaded guilty to criminal
charges relating to his role in the fraud.
The SEC admitted that it had ignored repeated signals that something was
wrong at the Madoff firm. Some eighteen years before the discovery of the
massive Madoff fraud, the agency had investigated Frank Avellino, who had
been acting as a money finder for Madoff, and charged him with promising
investors a guaranteed return of 20 percent per year. The SEC investigators
thought that they had discovered a Ponzi scheme, but they were reassured after
Avellino told them that the funds were invested with Madoff. The agency re-
quired Avellino to return $440 million in investor funds, but did not investigate
to determine Madoff’s role in this apparent Ponzi scheme.
The agency had received other credible allegations about Madoff’s Ponzi
scheme at least nine years before his confession, and it was alerted in 2006
that Madoff had misled it on the nature of his investments, but did nothing. In
addition, Harry Markopolos, a rival investor, had been telling the SEC for years
that Madoff had to be running a Ponzi scheme because the returns reported by
Madoff were not possible under the strategies that he claimed to be using. In
fact, investigators determined, after discovery of the fraud, that Madoff had
bought no securities for customer accounts for more than thirteen years.
SEC chairman Christopher Cox issued a statement expressing his concern
over the Madoff investigations and asked the SEC inspector general to review
the handling of those complaints and inquiries. Cox said he found the SEC
investigations to be “deeply troubling” because the agency had “credible and
specific warnings” of Madoff’s Ponzi scheme. The SEC inspector general
discovered that, in total, the SEC staff and the Financial Industry Regulatory
Authority (FINRA) examined Madoff’s operations eight times in sixteen years
but uncovered no evidence of his Ponzi scheme. They also let him off the
hook on a number of technical violations that they did discover. Most embar-
rassing, the SEC inspector general stated that SEC staff members had acted
incompetently in examining his operations, not even verifying the existence
of the assets that he claimed to manage. Yet an SEC staff member received

the agency’s highest performance rating because of the employee’s purported

ability to understand and analyze Madoff’s operations.
The SEC had failed to detect any of the massive accounting manipulations
during the Enron-era scandals. It simply did not have the staff to review the
accounting statements filed with it. The same problem was present in its invest-
ment adviser inspection program. The SEC’s Office of Compliance Inspections
and Examinations, which was responsible for the oversight of investment
advisers, was able to examine only 10 percent of the 11,000 SEC-registered
investment advisers every three years. The SEC used a risk assessment pro-
gram to prioritize its audits, but Madoff’s fraud, the biggest ever, did not show
up on their radar. Those infrequent examinations were also limited in scope.
Two Madoff victims sued the SEC, charging that it was guilty of “serial gross
negligence” in carrying out its regulatory responsibilities.
Even more embarrassing, after he registered as an investment adviser in
2006, in compliance with a new SEC rule requiring the registration of hedge
funds, no examination was made of Madoff’s operations. Laughably, in light
of Madoff’s fraud, the SEC had imposed that rule in order to stop hedge fund
fraud. Even worse, an appeals court held that the SEC had not properly acted
in imposing that requirement, but, unlike many other hedge funds, Madoff
never bothered to deregister.
JPMorgan Chase was sued for trading with Madoff’s brokerage firm and
for maintaining his checking accounts. New York Attorney General Andrew
Cuomo sued Ivy Asset Management, a unit of the Bank of New York, charging
that Ivy had concluded in 1998 that Madoff had lied about his investments.
Ivy then decided not to place additional investor funds with Madoff but did
not inform existing investors of this concern. Ivy continued to earn millions
in fees for maintaining those funds with Madoff over the next decade.
AIG was involved in litigation over whether its homeowners’ policies
covered losses from the fraud. It paid some claims for out-of-pocket losses
but refused to cover the fictitious profits reported by Madoff. The bankruptcy
trustee took the same approach and sought to claw back any profits received
by the more fortunate Ponzi scheme investors. The SIPC provided $500,000
coverage on accounts, but only covering actual out-of-pocket losses.
Suicides and Scandals
Articles were published in both the New York Times and the Wall Street Jour-
nal highlighting various suicides that appeared to be connected with financial
distress, and some of them were spectacular. René-Thierry Magon de la Ville-
huchet, cofounder of the investment advisory firm Access International Advi-
sors (AIA Group), which suffered some $1.5 billion in losses from Madoff’s
fraud, committed suicide on December 23, 2008. He lost $50 million of his
own money in the Madoff fraud as well as other family money. Jeffrey L.
Picower, who made some $7 billion in the Madoff Ponzi scheme, was found

drowned in his pool in Palm Beach in October 2009, apparently stricken by a

heart attack. He had been the target of numerous lawsuits and had a history of
heart problems. The son of another Madoff investor who committed suicide
was the subject of a BBC documentary on Madoff’s Ponzi scheme. The high-
light of the broadcast was an interview with an investor who had retained the
voluminous confirmation statements sent to her by Madoff for transactions in
her account. This raised the troubling issue of how Madoff was able to carry
out this fraud without a lot of clerical and computer support.
In another case, Scott Coles, the operator of Arizona Commercial Lender
Mortgages, donned a tuxedo and committed suicide after a large number of
loans that he had made turned sour. Kirk Stephenson committed suicide after
his investment firm lost a massive amount in the Lehman Brothers bankruptcy.
Adolf Merckle, one of the richest men in Germany, committed suicide on
January 6, 2008, by throwing himself under a train. His businesses were los-
ing large sums of money.
Patrick Rocca, described in the press as an “Irish property tycoon,” commit-
ted suicide in Dublin on January 20, 2009. One of the more shocking suicides
occurred on April 22, 2009, after it was discovered that David Kellermann,
Freddie Mac’s chief financial officer, had killed himself. He had been dealing
with the SEC and Justice Department investigations of Freddie Mac’s account-
ing issues. That must have been stressful, but he had just obtained a favorable
ruling from the SEC on the accounting treatment that allowed Freddie Mac to
avoid a $30 billion charge against earnings.
Ponzi schemes continued. The Madoff scandal was followed a few weeks
later by the discovery of a Ponzi scheme being run by Joseph Forte in Broo-
mall, Pennsylvania. He took in $50 million before confessing his scheme to
a postal inspector. In one of the more dramatic escapes, Marc Schrenker, an
investment adviser in Indiana accused of defrauding his customers, fled in
his airplane. Schrenker, who had been living a lavish lifestyle in Indianapolis
with his glamorous wife, Michel, jumped out of the airplane over Alabama.
The crashed, but empty, plane was discovered in Florida, 200 miles away.
No one was fooled, and Schrenker was found hiding in a campground near
Quincy, Florida, where he slit his wrist just before being captured. Schrenker
survived and was jailed.
Idaho authorities charged Daren Palmer and his hedge fund, Trigon Group,
with running yet a further Ponzi scheme in which investors lost over $100
million over seven years. In Sarasota, Florida, Arthur Nadel disappeared in
January 2009. Nadel had been operating hedge funds that he claimed had as-
sets worth $300 million, and he reported that they were earning on average
11 to 12 percent between 2000 and 2006. In fact, the hedge funds were worth
less than $1 million and had negative returns. Nadel was arrested on January
27, 2009.
On the day before the Nadel arrest, authorities took Nicholas Cosmo into
custody and charged him with operating a $380 million Ponzi scheme in

Hauppauge, New York. Cosmo was selling investors private bridge loans for
a minimum $20,000 investment and promised returns of 48 to 80 percent a
year. After he admitted to running a $55 million Ponzi scheme in Southern
California, Colin Nathanson was sentenced to twenty-seven years in prison.
Al Parish received a sentence of twenty-four years after he was found guilty
of running a $66 million Ponzi scheme in South Carolina. He was formerly an
economist at Charleston Southern University. Scott Rothstein, a flamboyant
lawyer in Florida who had operated a $1.2 billion Ponzi scheme, was given
fifty years.
Other frauds were uncovered. On the same day as the Madoff disclosures,
Steven Gordon of Bayview Financial was arrested for falsifying mortgage
applications by changing credit scores and identifying mobile homes as
single-family residences in order to qualify the mortgages for securitization.
He falsified information on more than 2,800 loans between 2001 and 2006
and earned more than $2.8 million in commissions on those loans. Bayview
agreed to make good on the securitized mortgages.
A new type of fraud appeared in the form of scams promising to help home
owners facing foreclosure. Homeowners were asked for an upfront fee, but they
received little or no services. The sharp increase in crude oil prices had given
rise to still another class of swindlers, who pushed fraudulent investments in
drilling operations. The SEC and state securities administrators investigated
dozens of such cases across the country.
The German engineering firm Siemens agreed to pay U.S. and European
authorities a record $1.6 billion to settle claims that it had paid bribes of $1.4
billion to land government contracts around the world. In a separate case, Fiat
agreed to pay $17 million to settle charges that it had paid kickbacks to Iraqi
government officials. David Drumm, CEO, and Sean FitzPatrick, chairman,
of the Anglo Irish Bank Corporation resigned in December 2008 after it was
disclosed that FitzPatrick had concealed some $125 million in personal loans
made to him by the bank. FitzPatrick was later arrested by the Irish Garda
and was being sued by the bank to recover $100 million of the loans that he
failed to repay.
A Bad Year Finally Ends
The Economy Continues to Struggle
The Fed surprised the market with a dramatic interest rate cut on December
16, 2008, pushing short-term Fed funds rates down to a target range of 0 to
0.25 percent. The average interest rate on thirty-year fixed-rate mortgages
then dropped to 5.17 percent, the lowest level in over forty years. The Fed rate
cut pushed the Dow up by 359.61 points, but it fell again on December 18 by
219.35 points. November retail sales were down by 5.5 percent, but here was
some good news. The price of crude oil fell to $36.22 per barrel on December

18, 2008, despite an announcement by OPEC that it would reduce production

by 2.5 million barrels a day.
Credit rating agencies contributed to the gloom (which they had largely
created through their rating downgrades). Moody’s announced that some $76
billion of commercial real estate CDOs were on credit watch, and it expected
that those obligations would be sharply downgraded. On December 19, 2008,
rating agencies also cut the ratings of eleven global banks—Bank of America,
Citigroup, Goldman Sachs, Morgan Stanley, Wells Fargo, JPMorgan Chase,
Barclays, UBS, Credit Suisse, the Royal Bank of Scotland, and Deutsche
Bank—which comprised most of the major financial institutions in the United
States and abroad. The government of Ireland announced over the weekend
of December 20, 2008, that it would supply $7.66 billion to the three largest
Irish banks, and it took control of the Anglo Irish Bank through a preferred
stock arrangement that gave it 75 percent voting rights.
A lengthy article was published on the front page of the New York Times on
December 21, 2008, suggesting that President George W. Bush was responsible
for the subprime crisis because he had sought to increase the number of minority
homeowners by 5.5 million in 2002. The article noted that the neighborhood
in Atlanta where Bush had announced that plan was struggling, with some 10
percent of the homes there in foreclosure. The American Dream Down Payment
Assistance Act, which President Bush had championed, provided as much as
$200 million annually to help first-time homeowners with their down payments
and closing costs, but may have inadvertently added fuel to the fire.
The New York Times article further reported that one of the Republican
Party’s top ten donors in 2004 was Ronald Arnall, the founder of Ameriquest,
one of the largest subprime lenders before the crisis. President Bush’s efforts
to rein in Freddie Mac and Fannie Mae by tighter regulation were discounted
as being more stringent than Congress could tolerate.18 Bush did not cover
himself with glory in those events, but his contributions to the subprime lend-
ing crisis paled in comparison to the groundwork laid by the administration
of Bill Clinton, which had imposed excessive quotas for subprime lending
on banks and Fannie Mae and Freddie Mac. Another front-page article in the
New York Times on December 25, 2008, reported that the number of federal
criminal prosecutions for financial fraud in 2008 was the lowest since 1991.
Criminal cases referred from the SEC to the Justice Department fell to just
nine in 2007.19
Commercial real estate developers approached the government for a bailout,
claiming that office buildings, shopping centers, hotels, and other commercial
buildings were in danger of default and foreclosure. This was because $530
billion in commercial mortgages were coming due for refinancing in the next
three years, of which $160 billion would have to be refinanced before year-end
2009. Little credit was available for those refinancings, and cash flows from
commercial property were declining.
Real estate investment trusts (REITs) experienced their worst year on record,

in a decline of some 40 percent by year-end 2008. The CIT Group, a large com-
mercial lender, faced bankruptcy in July 2009. It was a significant commercial
lender to small and medium-size businesses and had been in business for over a
hundred years. CIT carried $68 billion in liabilities and faced a liquidity crisis.
It converted to bank holding company status in order to obtain funds from the
TARP program. Although CIT had received $2.3 billion in TARP funds, it was
unable to qualify for the government program that would guarantee its debt
obligations, a facility that was made available to other financial institutions by
the government. The government took a strong stance against further aid to
CIT, which indicated its belief that the firm’s failure would not set off another
panic. A group of creditors then agreed to provide $3 billion in order to keep
CIT out of bankruptcy, but it went bankrupt on November 1, 2009, causing
an expected loss of the government’s bailout funds.
By December 2008, the FHA approved about 40,000 mortgages a month for
insurance, compared with 12,250 the previous year. The FHA insured about
10 percent of California mortgages that month, an increase over 2 percent the
year before. In all, the FHA was responsible for about a third of all mortgage
loans originated in the fourth quarter of 2008. It approved loans with down
payments as low as 3 percent, a minimum that was scheduled to increase to
3.5 percent in 2009. Even with that increase, a large number of defaults were
assured by this lack of concern over credit quality. Private mortgage insurers
required down payments of at least 10 percent for smaller mortgages and 15
percent for loans of more than $417,000.
The FHA did not limit loans on the basis of credit scores, while private
lenders placed increasing emphasis on such scores and required them to be
higher than in the past. Concern was raised that this difference would cause
the riskiest loans, the ones most likely to default, to be sent to the FHA, a
form of adverse selection. The FHA did limit loans to the point where the total
mortgage payments, excluding taxes and insurance, did not exceed 31 percent
of the borrower’s gross income.
By Christmas 2008, 25 banks had failed, and another 200 were on a regu-
latory watch list. Banks and savings and loan associations faced their first
combined quarterly loss since 1990 in the fourth quarter of 2008. The banks
cut their overseas lending by 5.4 percent in that quarter. There was, however,
some good news. The thirty-year fixed-rate mortgage interest rate averaged
only 5.14 percent at Christmas 2008, compared with 6.17 percent the previous
year. Mortgage refinancing applications boomed.
The ongoing mortgage loan modification programs continued to encounter
difficulties in obtaining permission from the owners of the securitizations in
which the loans had been packaged and sold. Investors in CDOs issued by
Countrywide sued to stop CDO loan modifications, and a federal judge ruled
in favor of those investors in August 2009. Another problem was that many
of the service organizations for those securitizations were equipped to do
little more than collect and pay out monthly mortgage payments. They did

not have the personnel to handle loan modifications or even, in some cases,
to supply loan histories and fees charged to individual loans. However, Bank
of America reported the modification of 230,000 mortgages, covering debt
of $44 billion.
A giant chemical company, LyondellBasell Industries, announced on De-
cember 30, 2008, that it faced bankruptcy. That company had been created by
a merger in 2007, and the debt load resulting from that merger, combined with
declining sales, caused deterioration in the company’s financial situation. An
auction to settle the credit-default swaps for the U.S. unit of LyondellBasell
valued its debt at just two cents on the dollar. Normally the recovery on de-
faulted junk bonds was around 40 percent.
Year-End Results
The Dow Jones Industrial Average closed up 108 points on December 31, 2008.
However, for the year the Dow was down 33.8 percent, losing 4,488.43 points,
the worst result since 1931. In that period, the S&P 500 fell 39.5 percent, falling
by 22.5 percent in the fourth quarter alone. The decline in the S&P 500 Index
in 2008 matched the decline in that index in 1937. In all, investors lost some
$7 trillion in the stock market during 2008. The average loss of equity-based
mutual funds was 36.7 percent for the year. A Wall Street Journal survey of
1,700 diversified U.S. mutual stock funds found that only one made money
in 2008, and its return was only 0.4 percent.
During 2008, household wealth in the United States shrank by $11.1 trillion,
about 18 percent. More than $5 trillion of that amount, about 9 percent, was
lost in the fourth quarter. The number of millionaires (those with investable
assets of that amount, excluding primary residences) in the country fell to 6.7
million in 2008, compared with 9.2 million in 2007, a decline of 27 percent.
Visa reported that in the fourth quarter of 2008 debit card volume had exceeded
credit card volume for the first time. Christmas retail sales were disappoint-
ing, falling by some 8 percent over the previous year. Retailers had the worst
holiday season since 1970. Consumer confidence dipped to a new low in
December 2008. Housing prices had fallen every month since January 2007.
The stock market continued to be highly volatile. The change in the S&P
500 exceeded 5 percent on eighteen separate trading days during the year,
whereas only seventeen such volatile trading sessions had occurred over the
previous fifty years. The Dow experienced two of the six largest one-day
percentage gains in its history in October 2008. The Dow also had the worst
one-week percentage decline in its history in October. Four of the twenty
largest daily percentage declines in its history also occurred in the last four
months of 2008.
Stock and bond underwriting shrank by 38 percent during 2008. The number
of IPOs plunged by 80 percent during 2008, and no new offerings were sched-
uled in early January 2009. Global merger activity contracted by 29 percent

in 2008, but there were still $3.06 trillion in deals. Three giant bank mergers
were completed in December 2008, including Wells Fargo’s acquisition of
Wachovia, making it the nation’s fourth-largest bank. PNC completed its $3.91
billion acquisition of National City, making it the nation’s fifth-largest bank.
In the meantime, twenty-eight banks and S&Ls failed between 2007 and 2008.
That was bad, but a far cry from the number of failures experienced during the
Great Depression or even during the S&L crisis in the 1980s.
Wells Fargo reported a $2.55 billion loss in the fourth quarter of 2008, a
loss attributed to its acquisition of Wachovia. However, the closing of the
acquisition of Wachovia did not occur until after year-end, so Wachovia’s
losses were not included in Wells Fargo’s results. This was fortunate, con-
sidering that Wachovia lost $11.2 billion in the fourth quarter of 2008, after
taking a $37.2 billion writedown on its subprime mortgages. JPMorgan Chase
reported a fourth-quarter profit, down 76 percent over the year before. Still,
things could be a lot worse. Citigroup had an $8.3 billion loss for the fourth
quarter, bringing its losses to $18.7 billion for 2008. It contemplated divid-
ing itself into two businesses, in which a new Citicorp would take over the
bank’s traditional banking operations, such as commercial banking, credit
cards, and investment banking, while the bank’s noncore operations would
be moved to a separate company, called Citi Holdings, but this plan stalled.
Vikram S. Pandit, Citigroup’s CEO, announced that he and other executives
at that bank would not receive bonuses for 2008, though his pay package still
totaled $38.2 million.
Bank of America and Citigroup’s stocks fell by more than 65 percent for
the year. Bank of America’s CEO, Kenneth D. Lewis, initially refused to reject
a bonus but finally gave in under pressure and agreed that he and other top
executives at the bank would forgo bonuses for the year. UBS announced a
reduction in its bonuses of more than 80 percent for 2008.
AIG lost $37.6 billion during 2008. Lehman Brothers lost $2.3 billion be-
fore it failed. Morgan Stanley had a fourth-quarter loss of $2.37 billion, but it
did have a profit for the year. Goldman Sachs reported a $2.1 billion loss for
the fourth quarter, but that loss was smaller than expected, and the firm had
an overall profit for its fiscal year. By year-end 2008, Washington Mutual had
lost $8 billion over the previous sixteen months. Legg Mason announced a
record $1.49 billion loss in the fourth quarter. Regions Financial Corporation
in Alabama lost $6.22 billion in the fourth quarter and had to obtain $3.9 bil-
lion from the government as a bailout. Other banks accepting bailout money
were Fifth Third Bank, which was given $3.4 billion; Great Southern Bancorp,
$58 million; and UCBH Holdings, $299 million.
Deutsche Bank reported a loss of $5 billion in 2008, its first loss in more
than fifty years, and had $6.3 billion in trading losses in the fourth quarter.
More than $1 billion of that amount was lost by a single trader, Boaz Wein-
stein. UBS posted a $6.96 billion loss in the fourth quarter and a loss for the
year of $17 billion. That figure had to be raised, embarrassingly, by $1 billion

in March 2009. The bank announced the elimination of some 2,000 jobs in
2009. Credit Suisse suffered a fourth-quarter loss of $2.75 billion and a loss
for the year of $6 billion. Lloyds Banking Group, which had acquired HBOS
as a part of a government-assisted rescue in 2008, reported a loss for the year
of $12 billion as a result of that acquisition.
Hedge funds were down on average 19 percent in 2008. The Citadel Invest-
ment Group saw its assets decline by 55 percent. At one point during 2008, the
stock of Hartford Financial Services Group was down by 94 percent. Warren
Buffett advised Berkshire Hathaway stockholders that the company had turned
in the worst performance ever in 2008. The company’s stock declined by 30
percent for the year. His personal fortune shrank by some $25 billion during
the subprime crisis, causing him to forfeit his position as the world’s richest
man to Bill Gates, the founder of Microsoft.
Prudential Financial lost $1.57 billion in the fourth quarter. Insurance com-
panies offering guaranteed variable annuity contracts had also suffered large
losses. These popular retirement contracts provided a rate of return based on
market performance, but the insurance company protected the customer from
any loss of principal. The SEC, thereafter, sought to extend its regulation over
annuity contracts by adopting a rule in early 2009 that subjected fixed-index
annuities to its regulation. These annuities credit the investor with a return
based on a stock index. However, the District of Columbia Circuit Court held
that the SEC had not acted properly in promulgating that rule.
Outside the financial sector, Shell reported a loss of $2.81 billion in the
fourth quarter of 2008, while ExxonMobil announced a $7.82 billion profit,
and Chevron posted a $4.9 billion profit. BP reported a record profit, $25.6
billion, in 2008, but issued a profit warning for 2009 because of concerns over
the decline in oil and gas prices. The year had certainly been a tumultuous
one for crude oil. Oil prices rose to $145.29 per barrel on July 3, 2008, but
closed at $44.60 on December 31, 2008. Dow Chemical reported an unex-
pected fourth-quarter loss of $1.55 billion. Time Warner announced a loss of
$16 billion in the fourth quarter. Kodak suffered significant losses, putting its
viability in question. Dell had a 48 percent drop in profit.
Overall, corporate profits fell by $250 billion, a decline of 16.5 percent, the
largest decline in fifty-five years. In total, profits at major companies in the
United States fell by 32 percent in 2008. Despite widespread losses, CEOs at
major companies around the world kept their jobs during the subprime crisis,
with a turnover rate in 2008 of 14.4 percent, compared with 13.8 percent in
2007. Nevertheless, CEOs at Citigroup and Merrill Lynch were unceremoni-
ously fired, albeit with generous compensation. In one eight-day period in
January 2009, CEOs at Tyson Foods, Borders Group, Orbitz, Chico’s FAS,
Seagate Technology, and Bebe Stores were all dismissed.
U.S. government bond funds did well in 2008, rising by an average 20.4
percent, of which 17.5 percent was acquired in the fourth quarter. However, the
yield on a three-month Treasury bill was only 0.016 percent. The Fed’s balance

sheet grew at the end of 2008 from $900 billion to more than $2 trillion. It had
purchased billions of dollars in mortgage-backed instruments of Freddie Mac,
Fannie Mae, and Ginnie Mae, but it had a long way to go to reach its goal of
$500 billion in such purchases by mid-2009. Fannie Mae had a $25.2 billion
loss in the fourth quarter, pushing its total losses for the year to $30.9 billion.
Freddie Mac reported a fourth-quarter loss of $30.8 billion, with a total for
the year of $50.1 billion. In March 2009, after posting its fourth-quarter 2008
results, Freddie Mac announced that it would request another $30.8 billion in
bailout funds from the federal government.
Moody’s predicted that Federal Home Loan Banks (FHLBs) would fall
below regulatory minimum capital requirements after they took expected
write-offs on their $76 billion in mortgage-backed securities, in addition to
$13.5 billion already written off. The FHLB in Seattle was the first bank in
the system to announce a capital shortage. The FHLB of Pittsburgh reported a
$187 million loss in the fourth quarter. The FHLB of Chicago lost nearly $120
million, and the FHLB of Boston lost $73.2 million. The FHLBs collectively
had borrowed about $1.3 trillion; however, they had a credit facility at the
Treasury Department that was untapped.
A study conducted by the Treasury Department concluded that the larger
banks receiving bailout money had not increased their lending in the fourth
quarter of 2008. However, Bank of America claimed that it had increased
lending by more than $115 billion in new credit in that quarter. Nevertheless,
lending fell in the fourth quarter of 2008 by 1.4 percent, despite all the money
infused into the banks by the federal government. There were reasons to hold
back. Mortgage delinquencies on office buildings, hotels, and shopping malls
rose sharply in the fourth quarter.
During 2008, the rating agencies downgraded over 221,000 tranches of
asset-backed securities, and banks experienced over $500 billion in losses on
subprime mortgages. At the end of 2008, more than 10 percent of all mort-
gages in the United States were delinquent for more than sixty days. Prime
loan delinquencies increased to 2.4 percent, up from 1.1 percent in the first
quarter of 2008. Subprime delinquencies rose from 11 percent to 16 percent.
That subprime rate was alarming, but it certainly did not justify the panic
experienced in the credit markets. Sales of new homes declined by 15 percent
in December. New home construction fell in December 2008 to the lowest
amount since records began to be kept on that statistic in 1959. Migration to
the Sunbelt slowed to a standstill. The overall slowdown in migration was the
greatest since the Great Depression. However, pending home sales increased
by 6.3 percent in December, and completed home sales rose by 6.5 percent
in December 2008, the largest increase in seven years. That increase was at-
tributed to declining housing prices. Median home prices fell to $180,800 as
2008 ended, compared with $230,900 in 2006. In Miami, housing prices were
down by 23.5 percent from their peak.
D.R. Horton, the largest home builder in United States, had better-than-

expected quarterly results at year-end, but its orders fell by 35 percent in the
fourth quarter. Still, that was better than the results reported by other builders,
which had declines of as much as 80 percent. KB Homes lost $772 million
in the fourth quarter of 2007, compared with $307 million in the fourth quar-
ter of 2008. However, Beazer Homes USA, the Atlanta builder, reported a
53.2 percent decline in home closings over a year earlier and orders for new
homes declined by 56 percent. Jumbo mortgages faced a rising delinquency
rate, climbing to 6.9 percent, up from 2.6 percent a year earlier. Concern was
also being raised that further massive losses in the so-called Alt-A mortgages
would follow because of reset provisions that could double mortgage pay-
ments in 2009.
The minutes of the Fed’s last meeting of the year in December 2008
evidenced a concern that the recession would be longer and deeper than had
previously been predicted. The economy was, indeed, in a tailspin. The gross
domestic product (GDP) contracted by 6.3 percent in the fourth quarter—the
largest drop in GDP since the recession in 1982 and was well above the 3.8
percent decline initially predicted by the Commerce Department. Stock buy-
backs declined by 65 percent in the fourth quarter and by 28 percent for the
year. Wholesale prices fell in December, removing any lingering concerns
over inflation. Consumer confidence was at another new low.
The number of people receiving unemployment benefits increased by 4.6
million in 2008, the most since 1982. The unemployment rate rose to 7.2
percent in December. Most of those job losses occurred in the fourth quar-
ter of 2008. Consumer spending fell by 3.5 percent during the quarter, and
spending on food was down 3.7 percent. Durable good orders shrank by 22.4
percent in the fourth quarter of 2008. Spending on business equipment and
software decreased by 27.8 percent during that quarter, the largest decline in
fifty years. However, productivity rose at an annual rate of 3.2 percent in the
fourth quarter.
Manufacturing activity around the world fell sharply in December. In the
United States, that activity plunged to its lowest level since 1980. Ford fore-
cast a 19 percent contraction in automobile sales, which turned out to be an
understatement. World trade was also in decline. Imports and exports by the
United States shrank by 18 percent between July and November 2008, mostly
from imports. Japan experienced a 3.3 percent decline in GDP in the fourth
quarter as its exports declined. State and municipal pension plans lost almost
30 percent of their value in 2008, a loss of some $900 billion.

The former chairman of the Federal Reserve, Alan Greenspan, once a hero, was being
blamed for the housing bubble. (Mark Wilson, photographer, Getty Images ©)
U.S. Treasury Secretary Henry Paulson (L) and Federal Reserve Chairman Ben
Bernanke testify before the House Financial Services Committee during the subprime
crisis. (Chip Somodevilla, photographer, Getty Images ©)

Lloyd Blankfein, chairman and CEO of Goldman Sachs. He led the firm that every other
investment bank tried to emulate, without success. (Jemal Countess, photographer,
Getty Images © for Time Magazine)
President of the Federal Reserve Bank of New York and later Treasury Secretary
Timothy Geithner was at the center of government efforts to bail out Wall Street during
the subprime crisis. (Emmanuel Dunand/AFP, photographer, Getty Images ©)

Angelo R. Mozilo, founder and CEO of Countrywide Financial Corporation. (Tim
Sloan/AFP, photographer, Getty Images ©)

James Cayne, the head of Bear Stearns when it failed. (Daniel Acker/Bloomberg News,
photographer, Getty Images ©)
Richard Fuld Jr. (L), CEO of Lehman Brothers when it failed. (Alex Wong,

Charles Prince, former chairman and CEO of Citigroup, led the bank to its near ruin.
(Photo by Tim Sloan/AFP, photographer, Getty Images ©)

Vikram Pandit, CEO of Citigroup, during the subprime crisis. (Bill Pugliano,

Maurice R. Greenberg, chairman of American International Group (AIG). His ouster
by Eliot Spitzer left AIG adrift. (Choi Jae-Ku/AFP, photographer, Getty Images ©)

Stan O’Neal, chairman, chief executive, and president of Merrill Lynch. His appetite
for risk brought down mighty Merrill. (Joe Raedle, photographer, Getty Images)

Bernie Madoff, the world’s greatest fraudster ever. (Photo by Daniel Acker/Bloomberg
via Getty Images ©)
New York attorney general

Andrew Cuomo continued
Eliot Spitzer’s attacks on
Wall Street. (Andrew H.
Walker, photographer, Getty
Images ©)

V
The Crisis Abates

14. The Rise and Fall of the Subprime Crisis
The New President
The New Year—2009
On the first day of trading in 2009, the Dow Jones Industrial Average jumped
by 258.30 points, to close at 9034.69. However, the first full week of trading
in the new year witnessed a disappointing decline of 4.8 percent in the S&P
500 Index, its worst performance since November. Crude oil prices remained
volatile, jumping by 40 percent between Christmas and the first week of January
2009, before sharply declining once again, and they dipped to $35.40 a barrel
on January 15, 2009. Layoffs were carried out at large companies across the
country, including Hertz, ConocoPhilips, and AMD. Alcoa announced on Janu-
ary 6, 2009, layoffs of 13,500 employees, about 13 percent of its workforce.
The company had posted a loss of $1.19 billion in the fourth quarter of 2008,
and its sales were down by 19 percent from the prior year. That news was
followed by a report that Boeing was laying off 4,500 employees. Microsoft
sustained an 11 percent decline in profits in 2008 and cut 5,000 jobs. A $100
million theme park, Hard Rock Park in Myrtle Beach, South Carolina, declared
bankruptcy on January 6, 2009, after having been in operation for only nine
months with few attendees.
On January 12, 2009, the Dow Jones Industrial Average fell by 125.21
points. Among the shares hit hardest was Citigroup, which had reported that
it would announce a loss of $10 billion for the fourth quarter of 2008. At this
point, Citigroup had received $45 billion in government bailout funds. The
market reacted badly to news of the most recent loss. Citigroup’s stock price
fell below $5 on January 14, 2009, for the first time since November. The Dow
dipped 248.42 points on that day, its sixth straight day of losses. On January
21, 2009, Citigroup appointed its new chairman: Richard Parsons, the head
of Time Warner, which had been struggling for years. Those problems raised
the question as to exactly what management abilities he would bring to the
faltering Citigroup.
625

626 The Crisis Abates
Responding to a request from President-elect Barack Obama, President

Bush, on January 12, 2009, asked Congress to release the remaining $450 bil-
lion in the $700 billion Troubled Asset Relief Program (TARP). The president-
elect stated that he would use $100 billion of those funds to stop foreclosures.
On January 13, 2009, the chairman of the Federal Reserve, Ben Bernanke,
announced that the government needed to provide more bailout funds to banks
and financial institutions from TARP. However, one report claimed that the
program was mishandled.
Politics as usual guided the bailouts. Representative Barney Frank (D-
MA), chairman of the House Financial Services Committee, used his politi-
cal influence to require the Treasury Department to supply $12 million from
TARP to rescue OneUnited Bank in Boston. He was undeterred by the fact
that the bank did not qualify for the program and was under investigation by
regulators. House Democrats revealed a proposed $825 billion stimulus plan
on January 15, 2009, which sought $275 billion in tax cuts and $550 billion
in new spending. However, Bernanke asserted that tax cuts and government
spending on infrastructure were unlikely to lead to a recovery, unless the Wall
Street financial institutions stabilized.
The delinquency rate for both prime and subprime mortgages was a record
7.88 percent as 2009. Late payments on subprime mortgages were a stag-
gering 21.88 percent. Homeowners owed $9.6 trillion on their mortgages,
which meant that a total of $750 billion in residential mortgage debt was
delinquent and that $196 billion in subprime debt was late by thirty days or
more. Economists predicted that the housing slump would worsen during
2009 and would not recover until 2010. Treasury Secretary Henry Paulson
considered selling off the portfolios of Freddie Mac and Fannie Mae, leaving
them only the role of mortgage guarantors. However, it was unclear what
effect such sales would have on the market. Moreover, without a government
guarantee the mortgages would be unsalable at anything other than fire-sale
prices, which meant that the government would retain its risk, regardless of
its course of action.
On January 16, 2009, JPMorgan Chase announced an expansion of its
mortgage loan modification program to include not only mortgages in its
own portfolio but also mortgages that it securitized. The value of those
mortgages totaled more than $1 trillion. The modifications were intended
to ease demands on borrowers and to avoid foreclosures. A drop in inter-
est rates should have aided modifications and eased the pain of high-rate
mortgage resets. Interest rates on thirty-year fixed-rate mortgages had
fallen to 4.89 percent by mid-January 2009. However, many lenders still
did not extend loans. It was estimated that only about half of refinancing
applications were approved. Toll Brothers tried to kick-start its residential
housing business by offering a 3.99 percent thirty-year, fixed-rate mortgage
for homes it was building that cost under $417,000, with no points to be
paid to the lender.

The Rise and Fall of the Subprime Crisis 627
Trouble Abroad
Unemployment was rising in Germany, reaching 7.6 percent as 2009 began.

The German government took a 25 percent ownership interest in Commerz-
bank, after injecting it with an additional $13.63 billion. The Bank of England
announced an interest rate cut of 0.50 percent on January 8, 2009, bringing its
interest rate to 1.5 percent, and it cut rates further in February, to 1 percent, a
record low. Canada cut its interest rates to their lowest level ever on January
20, reducing them to 1 percent.
On January 19, 2009, the British government announced the creation of
a $150 billion bailout program for its banks that limited their losses due to
problem assets. Share prices in Great Britain then fell because the government’s
rescue program was viewed as an admission of a worsening financial situation.
The Royal Bank of Scotland (RBS) disclosed that it would report losses of as
much as $41 billion for 2008, the largest loss ever for a British bank. RBS laid
off 9,000 employees, and the UK government raised its ownership interest in
the bank to 70.3 percent. The Global Investment House in Kuwait defaulted
on $3 billion in debt on January 8, 2009.
Banks were facing more than just financial problems. Lloyds TSB Group
agreed to pay $350 million to New York State and U.S. federal authorities to
settle claims that it had allowed Iran to illegally funnel billions of dollars through
American banks. Nine other banks were under investigation for similar conduct.
Some of the funds were used to buy materials that could assist in the develop-
ment of Iran’s nuclear program. Barclays later agreed to pay $298 million to
settle charges that it allowed accounts from Cuba, Iran, and other embargoed
countries to transfer large amounts of funds in and out of the U.S. A federal judge
reviewing the settlement called it a “sweetheart” deal but approved it anyway.
Scandal broke out in India in January 2009 after Satyam Computer Services,
a giant outsourcing firm, was discovered to have massively cooked its books.
Its founder and chairman, Ramalinga Raju, confessed to the scheme after it
became unmanageable. He stated that it was “like riding a tiger, not knowing
how to get off without being eaten.”1
Inauguration Day
January 20, 2009, was the worst presidential inauguration day in the his-
tory of the Dow Jones Industrial Average, which declined by 332.13 points,
to 7949.09. Bank stocks were hit the hardest, falling about 20 percent. The
Citigroup stock price fell to $2.80 a share from a high in 2008 of $27.50. The
plunge would continue, down to $.97 in March 2009. Bank of America’s stock
price fell to $5.10, down from $40.65 in 2008. State Street, a traditionally staid
bank located in Boston, saw its stock price fall by 59 percent on Inauguration
Day, after reporting losses of almost $5 billion related to subprime securities.
Moody’s downgraded State Street’s debt.

Financial service stocks were, on average, down by 70 percent on Inau-

guration Day. Market volatility continued. The Dow rallied by 279.01 points
on January 21, 2009, but the rain of bad news remained constant, and the
Dow experienced its worst January ever. Capital One Financial Corporation
announced on January 22, 2009, that it would write off an additional $1 bil-
lion to cover rising credit card defaults. General Electric Capital Corporation
announced on January 23, 2009, that its net for the fourth quarter of 2008 had
fallen by 44 percent. The company also warned that it expected an extremely
difficult year ahead. General Electric had been able to sell $10 billion in bonds
guaranteed by the Federal Deposit Insurance Corporation (FDIC) on January
5, 2009, in the largest such offering to date under that program, scheduled to
end on June 30, 2009. Financial analysts projected that firms covered by the
FDIC guaranteed loan program would raise more than $400 billion from such
offerings before its termination date.
The National Credit Union Administration (NCUA) stepped in on January
28, 2009, to rescue the Federal Credit Union wholesale network. The NCUA
guaranteed the uninsured deposits at institutions that serviced smaller credit
unions. The federal government pumped $1 billion into the largest wholesale
credit union, U.S. Central Credit Federal Union, in Lenexa, Kansas.
Pfizer acquired pharmaceutical rival Wyeth for $68 billion in late January.
That brought some optimism to the market because of the size of the deal and
the fact that Pfizer was able to obtain financing for the transaction. However,
the economy took another blow with the announcement on the same day of
layoffs at the firm totaling 65,000. Large-scale layoffs occurred at several large
companies, including Home Depot, IBM, General Motors, and Texas Instru-
ments. Macy’s announced 7,000 jobs cut. Total job losses in January 2009
reached almost 600,000, the highest in twenty-five years. The unemployment
rate rose to 7.6 percent. Several states faced a crisis in their ability to pay
unemployment benefits.
The personal savings rate of Americans jumped by 5 percent in January
2009, the highest rate in fourteen years, signaling a sharp cutback in consumer
spending. Manufacturing slowed further during January, but at a less rapid
rate. Retail sales rose 1 percent in January as retailers slashed prices. Hous-
ing starts fell during January 2009 to the lowest level in fifty years, and home
resales dipped by 5.3 percent. The price of residences in the twenty largest
metropolitan areas in the United States declined by 2.8 percent in January
2009, leaving prices in those areas down by about 30 percent from their peak
before the crisis. The International Monetary Fund (IMF) raised its estimate
for credit losses on U.S. assets from $1.43 trillion to $2.2 trillion.
Britain had its widest trade deficit since 1697, when records were first
kept. As noted, its central bank, the Bank of England, reduced interest rates
in January 2009 to 1.5 percent, their lowest level since the bank was created
in 1694. The economic summit at Davos, Switzerland, in January turned out
to be a glum affair. However, Wen Jiabao, the Chinese prime minister, and

his Russian counterpart, Vladimir Putin, used the occasion to lecture the West
on its failings and to demand greater roles for themselves in world affairs.
They were not the only ones worried about U.S. finances. Foreign investors
withdrew $148.9 billion from their U.S. assets during January.
The subprime crisis did not slow government investigations of business
practices. Halliburton agreed to pay $559 million to settle Securities and Ex-
change Commission (SEC) and Justice Department charges that a subsidiary
paid bribes to foreign officials in order to obtain business.
Regulatory Proposals and Stimulus
In February 2009 the Obama administration announced that it would stress

test the largest nineteen banks to determine their viability. Any problematic
bank that failed the stress-test scenarios would have six months to raise capital
privately. Failing that, the government would inject the bank with capital by
buying convertible preferred shares from the undercapitalized bank, which
would pay a 9 percent dividend and be convertible into common stock. At the
same time that their lack of capital was questioned, banks were placed under
enormous pressure to lend the funds that they received from the government.
However, as a JPMorgan Chase executive warned, forced lending could distort
the credit market and result in loans without proper credit support. One prob-
lem with restarting lending was that, as Vikram Pandit, the CEO of Citigroup,
pointed out, loans could be obtained at a lower cost in the secondary market
than through new originations.
The new Treasury secretary, Timothy Geithner, held a press conference on
February 10, 2009, to announce the Obama administration’s bailout plans. His
performance was long on rhetoric and short on specifics, but he did mention
the creation of a public/private fund that would provide up to $1 trillion in
financing to private investors to allow them to buy distressed mortgage-related
assets from banks. This plan met a rather cold reception because it contained
no detailed pricing mechanism for the assets that would be purchased and
sold. Geithner also announced an expanded program for supporting consumer-
based securitized loans, including student loans, credit cards, and car loans.
Geithner stated that the government planned to release the remaining $450
billion in TARP, but that large banks would have to pass their “stress test”
before receiving more funding. At his press conference, Geithner promised
to release another plan, at some time in the future, to provide assistance to
homeowners facing foreclosure.
In the meantime, mortgage-servicing firms were overwhelmed by fore-
closures. They had some respite as foreclosures slowed, pending debate and
passage of the Obama economic stimulus package. With the help of three
Republicans, that $838 billion package passed the Senate on February 11,
2009. The Obama administration played up the disarray in the economy to
help assure passage of the stimulus package. As soon as it passed, however,

the administration began to soft-pedal economic concerns with a speech by

the president before a joint session of Congress on February 24, 2009. The
stimulus package included an $8,000 tax credit for first-time homebuyers,
payments of as much as $64,000 to doctors who digitized their medical
records, health insurance for the unemployed, and $276.3 billion in tax
cuts. The tax credit for first-time homebuyers proved especially popular,
costing the government an estimated $1 billion in lost revenue, twice the
amount projected, but helpful for the housing market while the credit was
in place.
The stimulus package also included something called Build America Bonds,
which were non-tax exempt municipal and state government bonds that were
supported with a government subsidy for one-third of their interest payments.
The Obama administration later sought to make these bond subsidies per-
manent, albeit at a reduced subsidy of 28 percent. The New York Times later
reported that the investment banks underwriting these offerings were charging
higher than usual fees and that the offerings were sometimes underpriced,
allowing quick profits by investors at the expense of the municipalities. The
financial analysts at the investment banks were also questioning the viability
of such offerings in view of the increasingly bad financial condition of state
and municipal governments.
The stimulus package prohibited financial institutions that received govern-
ment bailout funds from hiring foreign employees. It also required steel and
other products used in stimulus-related programs to be made in the United
States. This “Buy American” approach appeared to be an effort to boost the
labor unions and to repeat the mistakes made in the 1930s with the Smoot-
Hawley tariffs, which were designed to force purchases only of goods made in
the country. Retaliation followed enactment of Smoot-Hawley, nearly halting
world trade in the 1930s. Canada, which purchased about 20 percent of U.S.
exports, threatened reprisals, and Japan protested the provisions in the Obama
stimulus package, as did the European Union. The Obama administration
defended the legislation as permitted by the World Trade Organization’s pro-
curement code, which allowed some buy-American provisions in government
purchases. Other countries, including Russia, erected trade barriers to bolster
their domestic industries against import competition.
The SEC
The SEC reeled from its failures during the subprime crisis. Mary Schapiro, the
new SEC chair appointed by Obama, set about restoring the agency’s reputation
through a number of aggressive enforcement actions and regulatory proposals
that read like a wish list for corporate reformers. The proposed reforms included
say-on-pay and director nominations by pension unions through proxy propos-
als that would be distributed at the company’s expense. Schapiro also sought
legislation to make the agency self-funding through fees, so that it would have

more independence from Congress. She also wanted federal securities laws to
be revamped to more effectively regulate securitizations.
Schapiro suggested that she might turn back the regulatory clock and re-
instate the SEC’s traditional tick test for short sales, which prohibited short
sales until there was an uptick in the price of the stock. The theory was that
this would prevent short-sellers from unfairly driving down prices through a
continuing stream of short sales at ever-falling prices. Fed chairman Bernanke
supported her in that effort. The SEC short-sale proposals were published
in April 2009. Another proposal would adopt circuit breakers to prohibit all
short sales in the event of large market movement. The rules that were initially
adopted only addressed naked short sales (short sales made without first bor-
rowing the stock for delivery), which had been an issue at the height of the
subprime crisis. This raised hopes that the SEC had realized that short selling
is good for the market as a disciplinary tool. Those hopes were short-lived. The
SEC proposed a modified form of its old uptick rule a few months later. The
agency adopted that rule in February 2010. It imposed short-sale restrictions
on stocks that dropped by 10 percent or more in a single trading day.
Senator Carl Levin (D-MI) and Senator Charles Grassley (R-IA) introduced
a bill called the Hedge Fund Transparency Act, which sought to require hedge
funds to register with the SEC and to report their net asset value and identify
their investors. Schapiro supported the regulation of hedge funds, as did Gary
Gensler, the administration’s nominee to become chairman of the Commodity
Futures Trading Commission (CFTC), who was under attack because of his
prior support of deregulation.
Not long after the Madoff fraud was uncovered, the Wall Street Journal
reported on its front page that another giant Ponzi scheme was under way,
this one managed by Danny Pang and involving hundreds of millions of dol-
lars, including some $700 million from investors in Taiwan.2 Only after the
Wall Street Journal article appeared did the SEC freeze his assets. The Justice
Department also charged him with money laundering. Just a few months after
his arrest, Pang was found dead in his home, his wife having been murdered
earlier under mysterious circumstances.
Another massive fraud was revealed on February 17, 2009, after the SEC
charged Sir R. Allen Stanford with defrauding investors of some $8 billion.
He had promised high returns from certificates of deposit, but he invested the
customer funds in illiquid assets. Stanford was a high-profile financier who
was an international cricket sponsor, operating from the Caribbean island of
Antigua through his Stanford International Bank. That bank attracted a massive
amount of funds from Latin American investors He made a number of loans
to the Antiguan government, which awarded him with a knighthood because
of his generosity. Stanford was particularly popular in Venezuela, despite its
socialist government, and contributed heavily to political campaigns in the
United States. The SEC had brought prior enforcement actions against the
Stanford firm but let the firm off with only a slap to the wrist. The agency’s Fort

Worth office had investigated the firm for two years before a case was finally
mounted. The SEC claimed that it stopped its investigation at the request of
the Justice Department and that it had encountered jurisdictional problems in
Antigua. However, an SEC inspector general report subsequently found that
SEC examiners had concluded on four occasions that Stanford was commit-
ting fraud, but no action was taken. Spencer Barasch, the head of the SEC’s
Fort Worth office, was found to have repeatedly stopped investigations of the
Stanford operations and then tried to represent Stanford after moving to private
practice. The SEC inspector general sought to have Barasch disbarred from
practicing law for this conduct. The SEC had other issues. On May 15, 2009,
the SEC inspector general announced that two senior enforcement attorneys
at the agency had apparently been trading on inside information about com-
panies under investigation. The matter was referred to the Justice Department
for further investigation.
In June 2009, the Justice Department indicted Stanford, along with five of
his cohorts. Among other things, the indictment charged that Stanford had paid
a $100,000 bribe to Leroy King, the Antiguan financial services regulator, in
order to deflect SEC inquiries made in 2005 and 2006 on the bona fides of
the Stanford bank. Stanford surrendered to U.S. authorities and was denied
bail. Though he had once been a billionaire, Stanford ran out of funds to pay
his attorney before the trial even began. He was then supplied with a lawyer
from the public defender’s office in Houston. Stanford was later able to claim
coverage for his attorney fees under a company insurance policy. He then went
through several sets of attorneys. Stanford remained in jail as a flight risk and
was assaulted by a fellow inmate.
Those problems were followed by the arrest of hedge fund managers Paul
Greenwood and Stephen Walsh on charges of defrauding investors of $553
million, including the University of Pittsburgh, which lost $65 million, and
Carnegie Mellon University, which lost nearly $50 million. At the time of his
arrest, Greenwood was living on a 300-acre horse farm in North Salem, New
York, where he was the town supervisor. Greenwood and Walsh had been
two of the unsuccessful owners of the New York Islanders hockey team. That
franchise seemed to be jinxed. It was sold to John Spano, who was arrested
for fraud shortly afterward. The team was then acquired by Charles Wang, the
former head of Computer Associates, which had been the center of a massive
Enron-era accounting scandal.
Conditions Remain Uncertain
Credit markets thawed a little. Corporations sold $78.3 billion in investment-

grade corporate bonds during the first six weeks of 2009. Cisco Systems sold
$4 billion in bonds on February 9, 2009. Nevertheless, the market was not
too happy with the Obama stimulus package. The Dow dropped to 7850.41
on February 13, 2009, and fell by 298 points, closing at 7552.60, on February

17, 2009, when the market was shaken by reports of the possible collapse of
economies in Eastern Europe and projected defaults on loans made to those
countries by Western banks.
The market was also affected by announcements from General Motors and
Chrysler that they would need at least $21.6 billion in government funding
to avoid bankruptcy. Citigroup was in talks with the Treasury Department to
obtain more financing. It was later agreed that the government would take a
34 percent ownership interest in Citigroup, which had reported losses of $28
billion in the previous five quarters.
On February 18, 2009, President Obama announced a $200 billion plan
to provide relief for mortgage loan modifications for homeowners who were
underwater and had their mortgages via Fannie Mae and Freddie Mac. An ad-
ditional $75 billion was to be used for modification of mortgages from private
lenders. The initial plan sought to limit loan payments to 31 percent of the
borrower’s income. They would be given a $1,000 per year “pay for success”
fee for making the modified mortgage payments.
This program, like its predecessors, was slow to get off the ground. Only
55,000 modification offers had been issued by mid-May 2009, by which time
Bank of America had separately modified the terms of some 50,000 mortgages
issued by Countrywide. BoA’s modifications were required by a settlement
with various states. However, loan modifications were no panacea for subprime
loan defaults. Some 65 percent or more of modified subprime loans fell into
delinquency not long after being modified.
On February 18, 2009, Freddie Mac completed a $10 billion loan offering,
the largest in its history, and about two weeks later its CEO, David Moffett,
who had been brought in by the government only six months earlier to reor-
ganize the company, resigned. Fannie Mae disclosed on February 26, 2009,
that it needed another $15 billion in funds from the federal government. In
the meantime, Freddie Mac and Fannie Mae had been converted into govern-
ment entities to manage mortgage loan modification programs, to refinance
troubled loans, and to expand mortgage lending. Incredibly, the government
also pushed them into further easing their lending guidelines so that they could
continue to offer subprime loans.3
The price of gold passed $1,000 an ounce on February 20, 2009, and pre-
dictions of $2,000 per ounce were floated.4 The Dow was down 50 percent on
February 23, 2009, from its high of 14087 on October 1, 2007. The market
was hurt by predictions that American International Group’s (AIG’s) losses
for 2008 would total $100 billion. The rating agencies also applied downward
pressure on the market when they began downgrading life insurance companies
as the portfolio values of their reserves declined.
President Obama tried to sound upbeat in his State of the Union address
delivered on February 24, 2009. On the same day, Fed chairman Bernanke
testified before Congress and expressed confidence that the economy would
recover by 2010. He denied any interest in nationalizing large banks like Citi-

group, stating, “nationalization, to my mind, is when the government seizes the

bank, zeroes out the shareholders and begins to manage and run the bank. And
we don’t plan anything like that.”5 This statement was made after bank stock
prices in the United States tumbled upon reports that Chris Dodd, chairman
of the Senate Banking Committee, had asserted that some large banks might
have to be nationalized.
With respect to the subprime crisis President Obama said, “This crisis is nei-
ther the result of a normal turn of the business cycle nor an accident of history.
We arrived at this point as a result of an era of profound irresponsibility that
engulfed both private and public institutions from some of our largest companies’
executive suites to the seats of power in Washington, D.C.”6 He also stated, “For
decades, too many on Wall Street threw caution to the wind, chased profits with
blind optimism and little regard for serious risks—and with even less regard for
the public good.”7 The president outlined seven principles for designing a new
financial regulatory structure, to include “serious oversight” of large institutions
that pose systemic risk; reform of the present regulatory structure; transparency;
uniform regulation of financial products; accountability; comprehensiveness;
and recognition of the global nature of financial services.8
In February 2009, the Dow Jones Industrial Average declined by 12 percent,
closing at 7062.93 on the last trading day of the month. U.S. manufacturing
fell by only 1.4 percent, the smallest decline in four months, but auto sales in
the United States shrank by 41 percent that month. General Motors warned
that its European operations would run out of money in the next few months.
Consumer confidence fell to the lowest level in forty-one years. Many com-
panies, including Microsoft, Office Depot, Target, and Macy’s, faced further
declines in earnings. Wal-Mart reported strong sales, as consumers sought
low prices. That little bit of good news was quickly offset by a report that
the unemployment rate had risen to 8.1 percent in February 2009, the highest
rate in twenty-five years. Job losses for the month totaled 697,000. The Fed’s
Beige Book indicated that the recession had deepened in January and February
2009, as consumer and business spending fell. The Fed found sharp declines
in manufacturing, weak conditions in the agriculture sector, and a slowing of
mining and drilling.
The Federal Housing Administration (FHA) reported that mortgage loans
that were delinquent by ninety days or more had increased in February 2009
to 7.46 percent, up from 6.16 percent a year earlier. Judges in Lee County,
Florida, one of the hardest-hit areas in the country in terms of real estate
foreclosures, had another solution. They created a “rocket docket” for fore-
closure proceedings that foreclosed 1,000 homes per day. As foreclosure sales
increased, existing home sales jumped by 5.1 percent in February. Declines
in housing prices and bank loan delinquencies still grew but at a slower rate,
and home construction increased 22 percent in February 2009. Overall home
sales in California rose by an astonishing 83 percent year on year. New home
sales also rose in February, for the first time in seven months.

Lending by the large banks that had taken TARP funds declined by 23 per-
cent in February 2009 compared with October 2008, when the program went
into effect. General Electric (GE) suffered from concerns with its GECapital
unit, which made loans to small-to-medium-size businesses and invested in
commercial real estate. GE’s stock price plunged as concerns grew over the
mounting losses in that unit. The firm wrote down $4 billion on its commercial
real estate holdings and reserved about $10 billion for losses on $380 billion
in receivables due GECapital. GE announced on February 27, 2009, that it
would cut its quarterly dividend for the first time since 1938, by 68 percent,
from $.31 a share to $.10.
Those steps were not enough to protect GE’s coveted triple-A rating, which
it lost on March 12, 2009, after having held it since 1956. Standard & Poor’s
downgraded GE to AA, still investment grade and with a stable outlook. That
downgrade removed uncertainty over GE’s condition, and the company’s stock
price jumped 11 percent. The Obama administration considered the imposi-
tion of a requirement to mandate spinning off GECapital as a new structure
to be regulated as a bank, but GE fought that effort and eventually prevailed.
However, faced with charges that the firm had manipulated its accounts to
increase earnings in 2002 and 2003 by $780 million, it accepted a settlement
with the SEC in August 2009 and agreed to pay $50 million to settle those
charges. GE had been famous for meeting and exceeding analysts’ expecta-
tions every quarter, and these manipulations were conducted in order to assure
that result.
Dividends were cut at numerous companies, including JPMorgan Chase,
PNC Financial, CBS, the New York Times, Dow Chemical, and Pfizer. It ap-
peared that 2009 would be the worst year for dividends since 1938. By the end
of the first quarter alone, dividends had been reduced by more than $40 billion,
and public companies that reduced dividends numbered 367. However, Oracle
announced in March 2009 that it would pay a dividend for the first time.
Kaspar Villiger, a former finance and defense minister of Switzerland,
became the new chairman of UBS in March 2009. This was the second effort
to deal with UBS’s burgeoning subprime and tax shelter problems by bring-
ing in a new chairman. At the end of February 2009, HSBC announced that
it was cutting back its U.S. consumer finance operations, the remains of its
acquisition of Household Finance, and would raise $17 billion in new capital
through a rights issue. HSBC had suffered $10 billion in losses from over
the six years since acquiring Household Finance, and its acquisition of those
operations was one of the factors that gave legitimacy to subprime lending by
banks. Michael Geoghegan, HSBC’s CEO, said in 2009 that, “with the benefit
of hindsight, this is an acquisition we wish we had not undertaken.”9 That was
certainly an understatement.
Bank of America’s CEO, Kenneth Lewis, asserted on March 2, 2009, that
it had been a tactical mistake for the bank to have accepted TARP funds be-
cause it made the bank appear weak. The bank’s stock had lost 86 percent of

its value over the previous twelve months, but he said BoA would repay the
TARP funds over the next two to three years. Lewis lost a shareholder vote
on his continuation as both chairman and CEO. He was then stripped of his
chairmanship by the board but continued as CEO. He remained a subject of
controversy as Congress, the SEC, and New York attorney general Andrew
Cuomo continued to probe his role in trying to walk away from the Merrill
Lynch acquisition. Cuomo subsequently charged Lewis with fraud in not
disclosing the unexpected losses at Merrill Lynch before the shareholder vote
on the merger. Lewis hired Sallie Krawcheck, who had previously been CEO
of Global Wealth Management at Citigroup, as a possible successor. Vikram
Pandit, the Citigroup CEO, had previously forced her from her position at
Citigroup. She was eventually beaten out of the Bank of America job by Brian
Moynihan, a longtime Bank of America employee.
Executive Compensation
A Populist Issue Returns
The subprime crisis renewed populist and political focus on executive com-
pensation. A study published in November 2008 found that top executives
at 120 public companies involved directly in the subprime crisis and credit
crunch received compensation that totaled more than $21 billion during the
previous five years. Representative Henry Waxman (D-CA) held hearings in
2008 on the severance compensation paid to Charles Prince at Citigroup, F.
Stanley O’Neal at Merrill Lynch, and Angelo Mozilo at Countrywide Finan-
cial. All of those executives had led their firms into failure or near-failure, so
members of Congress questioned them severely. Senator Carl Levin (D-MI)
was a particularly aggressive corporate critic.
The Democrats had plenty of ripe targets. Fifteen corporate executives at
home building and financial services firms each received more than $100 mil-
lion in compensation during the five-year period leading up to the subprime
crisis. Mozilo alone took home over $470 million before Countrywide Financial
had to be rescued by Bank of America. Robert Toll at Toll Brothers took home
$427 million before that company’s housing sales dropped precipitously dur-
ing the subprime crisis.
Executives at large firms in the United States experienced an 8.5 percent
drop in median salary and bonuses in 2008, down to a median of $2.24 mil-
lion. However, when stock options were added in, median compensation fell
by only 3.4 percent, to $7.56 million. Some of the winners were Sanjay Jha,
who received over $100 million at Motorola; Lawrence Ellison at Oracle,
who received $84.6 million; Robert Iger at Walt Disney, who received $51.1
million; and Vikram Pandit at Citigroup, who received $38.2 million. Aubrey
McClendon, the CEO of the Chesapeake Energy Corporation, was paid $112
million in 2008, despite a steep decline in the price of the company’s stock.

Among other things, the company agreed to pay McClendon over $12 million
for his art and map collection.
Robert Rubin, treasury secretary in the Clinton administration and a Citibank
senior executive, was paid $115 million by Citigroup between 1999 and the
end of 2008, when he left because of the bank’s losses. Four CEOs serving at
Citigroup between 1998 and 2008 were paid a total of $483.1 million, which did
not include profits from their options. Prince, who was ousted from Citigroup
in 2007 as its losses mounted during the subprime crisis, had been given a $23
million compensation package for 2005. Citigroup’s net profit for the fourth
quarter of 2006 fell by 26 percent, but he received a princely $26 million for
his work during the year.
Ronald Logue, the CEO of State Street, was paid $28.7 million in 2008, an
increase of $5 million over his pay in 2007. That remuneration was granted
even though the price of the company’s stock fell from a high of $83 in 2008
to $22.63 on March 13, 2009, when his compensation package was announced.
State Street also reported $3.6 billion in unrealized losses, resulting in a credit
downgrade, and it was the recipient of $2 billion in government bailout funds
in 2008.
More fuel was added to the executive compensation fire after it was an-
nounced that executives at Fannie Mae and Freddie Mac would receive reten-
tion bonuses totaling $210 million. Both companies had failed in 2008 after
massive losses and were placed in government-managed conservatorships. In
remarks made on January 29, 2009, President Obama called bonuses of nearly
$20 billion paid out to bank executives, while the government was bailing
them out with taxpayer funds, “outrageous,” “shameful,” and the “height of
irresponsibility.”10 Five days later, the president went further, announcing that,
in the future, firms receiving bailout money would have to adopt a salary cap
of $500,000 for executives, golden parachutes were prohibited, and spending
on such things as corporate jets, office renovations, and holiday parties would
have to be disclosed.
On February 11, 2009, Congress called executives from eight of the major
financial firms—including Pandit at Citigroup, Jamie Dimon at JPMorgan
Chase, Lloyd Blankfein at Goldman Sachs, and Kenneth Lewis at Bank of
America—for seven hours of testimony on their compensation arrangements.
This experience persuaded Blankfein that the anger over bonuses at financial
services firms was “understandable and appropriate,” as he put it in an ad-
dress in Frankfurt, in September 2009.11 Nonetheless he did not offer to return
to Goldman shareholders the record bonuses he received in 2006 and 2007,
totaling $124 million, or the $1.1 million he received in 2008, at a time when
Goldman posted its first-ever quarterly loss as a public company.
Senator Claire McCaskill (D-MO) introduced a bill that would limit execu-
tive pay at companies receiving bailout funds to no more than $400,000—the
same amount that the president of the United States is paid (in addition to
$50,000 in travel expenses and $19,000 for entertainment, and perks like Air

Force One and a private residence at the White House) and what Blankfein
was paid every two days in 2007.
Bonuses at AIG
Anger mounted after the announcement that AIG paid $165 million in bonuses
for the 2008 work of the executives in AIG Financial Products (AIGFP), the
unit that caused most of the losses at AIG and resulted in a $170-plus billion
government bailout in 2008. Lawrence H. Summers, who succeeded Rubin
as treasury secretary under the Clinton administration and was now a senior
economic adviser to Obama, called those bonuses “outrageous.” However,
he was not averse to excessive compensation for himself, having received
$5.2 million in the previous year for his work at the hedge fund D.E. Shaw
& Company, as well as $2.7 million in speaking fees, mostly from financial
services firms.
President Obama weighed in with a threat to employ every legal method
to reclaim the AIG bonuses. His administration had some basis for taking
that action, because the American taxpayer owned 80 percent of AIG after its
bailout. Outrage grew after the president’s comments, and after it was revealed
that more than $1 million was paid to each of seventy-three employees on an
accelerated basis, including almost all the employees in AIGFP.
AIG claimed that the bonuses were needed to retain key employees. How-
ever, $33.6 million in bonuses was paid to employees who left the firm. More
criticism was leveled at AIG after it was reported that the company had con-
tinued to retain the risk managers who were on duty when AIG took on the
positions that caused it to fail. Another controversy arose over AIG’s bonus
pool for 2010. Kenneth Feinberg, whom the Obama administration appointed
special master for TARP executive compensation (called the “pay czar”),
sought to require AIG to reduce $198 million in bonuses already promised for
2010 and to recover $45 million already paid out to employees. Some of those
AIG employees resisted that effort. To add insult to injury, AIG was suing the
government for a $306 million tax refund, claiming, among other things, that
it had overpaid taxes as a result of its own accounting manipulations in 2004.
However, the IRS responded at the end of March 2009 with the disclosure that
it was investigating whether AIGFP had improperly structured tax shelters for
some large financial institutions.
New York attorney general Cuomo began an investigation of the AIGFP
bonuses. He and Representative Frank called for disclosure of the names of
executives receiving the AIG bonuses, even though they were targets of a
number of death threats. Cuomo was given the names, but under a confidential-
ity agreement. He then began harassing and threatening those executives and
announced at the end of March 2009 that some of them had agreed to return
about $50 million of the disputed bonuses, but others refused to do so.
One of the AIG executives agreeing to repay his bonus was Douglas Pol-

ing, who had received $6.4 million for his role as the lawyer for the financial
products division. He had been accused of silencing an in-house auditor who
had raised concerns about the accounting treatment for a joint venture led by
Poling. The other result of this furor was that some twenty key employees left
AIGFP, slowing the winding-down of that unit and damaging the taxpayers’
investment in AIG. The controversy over the AIG bonuses led to the resigna-
tion of two key AIG executives in France who managed Banque AIG, which
had billions of dollars in exposures that could be endangered by mismanage-
ment, and triggers on those exposures could be set off if French officials did
not approve their replacements.
The AIG bonuses resulted in some embarrassment for the Obama administra-
tion. The administration and the Treasury Department gave mixed signals on
the bonuses. Geithner concluded that they were legally valid, while President
Obama ordered their repayment. Geithner had been one of the architects of
AIG’s rescue while head of the Federal Reserve Bank of New York, and he
had been monitoring it as the bonuses were being paid. Senator Chris Dodd
(D-CT) also admitted to adding language in a recently passed stimulus pack-
age that authorized the bonuses. However, Dodd claimed that he had done so
at the request of Treasury officials.
The outrage over the AIG bonuses continued to swell in the press and
public. One poll found that 83 percent of Americans believed that the federal
government should limit the amount of compensation paid to executives at
firms receiving bailout funds. However, another poll found that only one-third
of Americans thought that bonuses should otherwise be restricted. That con-
trasted with the views of Europeans, where support for bonus curbs ranged
from 65 to 79 percent.
The House passed special legislation to impose a 90 percent surtax on
the income of employees earning more than $250,000 at companies that
had received $5 billion or more in government bailout funds. The law’s ef-
fect was not limited to AIG. If enacted, it would have affected thousands of
employees at firms receiving bailouts, including Goldman Sachs, JPMorgan
Chase, Morgan Stanley, Citigroup, and Wells Fargo, as well as Fannie Mae
and Freddie Mac.
Edward M. Liddy, a former Goldman Sachs board member brought back
from retirement for $1 per year in order to save AIG, was pilloried in Congress
and the press over AIG bonuses. Liddy said the once-sterling AIG brand had
become so tarnished that it would have to change its name in order to stay
in business. Robert Benmosche, who had previously conducted a successful
turnaround at MetLife, replaced Liddy as AIG’s CEO in August 2009, the
fifth CEO at AIG since 2005, when Hank Greenberg was ousted by New York
attorney general Eliot Spitzer. That hire and his compensation package were
valued at about $10 million. Interestingly, Feinberg approved that compensa-
tion package. Benmosche, who started his job by taking a two-week vacation
in Croatia, consulted with Greenberg to tamp down the war waged by one of

his predecessors, Martin Sullivan, against Greenberg. That effort was almost
immediately successful. AIG and Greenberg agreed on August 31, 2009, to
settle their claims and to privately arbitrate any issues that could not be settled
in an agreement formalized on November 25, 2009. The parties dropped all
claims against each other, and AIG agreed to pay Greenberg an amount to be
determined by an arbitrator, but not to exceed $150 million. The company
also agreed to return personal items from Greenberg’s office that were seized
when he was ousted. Greenberg later sold $278 million of his AIG shares to
UBS AG through a variable prepaid forward sale. Under that arrangement,
Greenberg was given an upfront payment for delivery of the shares at a future
date and a promise of being allowed to share in increases in the share price
in a specified amount.
The Controversy Continues
Waxman complained that the banks receiving TARP funds had expended $108
billion for employee compensation and bonuses for the first nine months of
2008. Cuomo took it a step further in July 2009, disclosing that nine financial
services firms receiving government bailout funds during the subprime crisis
in 2008 had paid out bonuses that year totaling $33 billion. Those firms paid
more than $1 million in bonuses to each of almost 5,000 employees. Although
that was an 11 percent decline from 2007, the amounts were still staggering.
The TARP legislation limited tax deductions on executive pay at firms
receiving bailout money to $500,000, prohibited golden parachutes in excess
of three years’ pay, and allowed clawbacks of bonuses in cases in which an
executive knowingly provided false financial information to the company that
affected the bonus. Recipients of TARP funds also had to certify that their com-
pensation schemes did not encourage excessive risk taking, left undefined.
Previously the special master in charge of the compensation fund for vic-
tims of the 9/11 attacks, disbursing $7 billion in the process, Feinberg was
now charged with monitoring compliance with executive compensation limits
imposed on the top 100 executives at firms receiving TARP bailout funds.
Feinberg reported directly to Treasury Secretary Geithner, but there was no
appeal from his decisions.
Feinberg oversaw pay practices at Bank of America, Citigroup, Wells Fargo,
and AIG, as well as General Motors and Chrysler and their finance units. His
attention focused on GM’s investment management unit, Promark Global
Advisors, which managed $102 billion in pension funds and $18 billion for
institutions and whose managers were paid $2 million or more. Restrictions
on pay delayed GM’s efforts to obtain a new chief financial officer (CFO), a
critical position that needed to be filled.
Feinberg found that seventeen firms receiving TARP funds had paid out
$1.58 billion in unwarranted bonuses after receiving those funds. Citigroup was
the worst abuser, largely due to the $100 million it was contractually required

to pay two traders at its commodity unit. Feinberg then caused Citigroup to
sell that highly profitable Phibro energy trading unit because one of its traders,
Andrew Hall, earned a $98 million bonus in 2008 and was looking at a $100
million bonus package in 2009, bonuses to which he was entitled under the
terms of his employment contract. The unit was sold to Occidental Petroleum
at what was then viewed to be a bargain basement price, but Phibro went on
to sustain large trading losses in 2010.
Feinberg trained his attention on guaranteed bonuses, which were becom-
ing the newest focus for corporate reformers. His deepest stroke was made in
October 2009, when he ordered cuts averaging 50 percent for salaries of 175
of the highest-paid executives at firms receiving TARP funds. He set off a
controversy when the administration refused to allow FOXNews to be a part
of a reporting pool interviewing Feinberg over the cuts, claiming that it was
not a legitimate news organization.
The Obama administration’s stimulus package added more restrictions on
executive pay for companies receiving TARP funds and other government
assistance, going beyond those in the original TARP legislation. Among other
things, it extended the reach of its prohibitions to include additional executives;
it required the firms to adopt policies prohibiting excessive entertainment or
luxuries; it limited bonuses to no more than one-third of total annual compen-
sation, except for allowing long-term restricted stock; and shareholders were
required to be given a nonbinding say-on-pay vote.
Dimon at JPMorgan stated that, when they criticize compensation of bank-
ers, politicians should distinguish between well-run banks (like his own) and
faltering financial institutions (like Citigroup). President Obama did so when
he publicly chastised Citigroup in January 2009 for failing to cancel an order
for a $50 million corporate jet, until it was put on the spot by the government.
Citigroup then tried to back out of a $400 million marketing arrangement
with the New York Mets baseball franchise in the hope of avoiding further
criticism of its spending.
Bank regulators investigated whether Fiderion Group, an executive search
firm, had improperly entertained Regions Financial Corporation executives,
after it was reported that Fiderion had spent more than $100,000 on golf out-
ings for those officials over a six-year period. This disclosure was made after
Regions received $3.5 billion in government bailout funds.
Cuomo used his investigation of bonuses paid to Merrill Lynch executives to
lever himself into a position to negotiate legislation with Congress that would
tie the pay of Wall Street executives to long-term performance. He wanted to
require public companies to defer bonus payments over several years, in order
to assure that the bonuses were properly awarded. Ironically, Cuomo targeted
Merrill Lynch’s bonuses even though that firm had implemented just such a
bonus system in 2006, tying compensation to long-term performance. Repre-
sentative Frank expressed support for that proposal and persuaded the House
to approve a bill in July 2009 giving the SEC authority to ban compensation

arrangements that provide perverse incentives to take undue risk at companies

with assets in excess of $1 billion.
Corporate reformers proposed caps on the pay of CEOs that would limit
their compensation to no more than twenty times the average worker’s salary.
Cornell economist Herbert H. Frank, in an op-ed piece in the New York Times
on January 4, 2009, argued that such a cap would discourage the most talented
executives from accepting a position as CEO. He supported a cap on salaries
for executives working at financial service firms receiving government bailout
money but asserted that the “more prudent response” to excessive executive
compensation at other firms was to raise marginal tax rates.12 However, that
had been tried in the past; highly paid individuals simply turned to tax shelters
or evaded high taxation in some other way. The subprime crisis did have some
effect on wealth distribution. The number of individuals with $30 million or
more fell by 25 percent in 2008.
As outrage over AIG bonuses continued to mount, the Obama administra-
tion considered proposals that would regulate the income of executives at all
financial services firms, not limited to those who received bailout money, tying
their executive pay to long-term performance. This caused a strong reaction in
the business community. Treasury Secretary Geithner clarified the administra-
tion’s approach on May 18, 2009, saying that it would not seek to set caps on
pay but would, instead, seek to prevent executives from taking large amounts
of short-term risk at the expense of their firm and the financial system. That
seemed rather odd, however, since, by definition, the mortgages that had caused
the subprime crisis were long-term instruments and were rated triple-A.
Geithner further stated that the government would focus on golden para-
chutes and procedures to assure that compensation was aligned with risk man-
agement. He also wanted legislation for say-on-pay votes and requirements
that members of compensation committees all be independent directors. This
did not stop the backlash in the financial community. Business leaders began
to express less enthusiasm for further participation in government bailout
programs. Several large banks announced they would return bailout funds
already received to avoid having their compensation dictated by Congress.
President Obama then backed off his threats of retaliation against AIG execu-
tives who received bonuses and even questioned the propriety of the House
legislation. The House then passed another bill that prohibited unreasonable
or excessive bonuses, as defined by the Treasury Department, and mandated
that bonuses be performance based. That legislation was not adopted, but
other compensation restrictions were included in legislation that was enacted
in 2010 (see Chapter 15).
The SEC also weighed in on executive compensation. Mary Schapiro, the
new SEC chair, announced in June 2009 that her agency would propose rules
requiring additional disclosures on compensation calculations for lower-
ranking employees who receive large payouts, such as traders at a financial
services firm. The SEC also proposed requiring disclosures on how compensa-

tion plans affected risk taking by employees and exploring how the company
was managing those risks. This seemed to be another effort to discourage risk
taking without any thought about the consequences.
A group of business leaders from the Conference Board sought to head off
further government intervention in September 2009 by proposing self-imposed
curbs on executive pay, including banning golden parachutes, gross-ups to
pay for additional taxes imposed on executive income, and personal use of
corporate jets. Wells Fargo and Citigroup, which were subject to the bailout
restrictions, sought to maintain the level of their top executives’ pay through
salary increases, which were not risk based—bringing us full circle to the
Omnibus Revenue Reconciliation Act of 1993, which demanded that firms
do just the opposite. JPMorgan Chase, Morgan Stanley, and UBS announced
similar plans. Merrill Lynch, however, which had received TARP funds and
had to be rescued by Bank of America at the insistence of the government
during the subprime crisis, awarded signing bonuses in the summer of 2009
that were larger than those at the height of the real estate bubble.
A contrite Blankfein declared in April 2009 that the compensation system
on Wall Street was flawed and that the large bonuses given to executives at
firms that failed “look self-serving and greedy in hindsight.”13 However, after
Goldman Sachs reported its second-quarter results on July 14, 2009 (the larg-
est ever reported by that firm—$3.44 billion, more than the firm earned in all
of 2008), Blankfein set aside $11.4 billion for year-end employee bonuses.
Bonuses had shrunk by 70 percent at Goldman in 2008, displeasing its execu-
tives. Goldman Sachs extended loans to its employees in March 2009. Many
of those employees had suffered losses on their Goldman Sachs investments
and received margin calls from their own firm.
Wall Street investment banks reserved $36 billion in the first quarter of 2009
for year-end bonuses, a pace, if kept up for the rest of the year, that would
provide payouts near the record levels set in 2007. Bonuses were needed. Re-
strictions on pay at Merrill Lynch, Citigroup, and UBS, which were imposed
after they received bailout money, led some talented employees to be lured
away to other firms that offered richer compensation packages. One executive
headhunter estimated that those financial institutions had lost a quarter of their
most productive employees. Bidding wars for talent broke out on Wall Street
as the second quarter ended in 2009.
Risk and innovation on Wall Street continued to be targets of hysteria. A
front-page article in the New York Times on September 6, 2009, claimed that
“new exotic investments” started to appear on Wall Street.14 The article focused
on life insurance policies purchased from the ill and the elderly and then securi-
tized. However, such viatical investments have been around for a long time and
are frequently abused. This type of policy was the subject of somewhat sordid
auctions at the Royal Exchange in London as early as 1844, in which the dying
beneficiaries were trotted out for bidders to judge their life expectancy. Scam art-
ists involved in viatical contracts also underpaid AIDS victims for their policies

150 years later and took advantage of the elderly and infirm. Securitization was
one way to meet the needs of the dying by giving them access to the proceeds
of their policies when they needed the funds while also assuring a fair price. In
any event, these products were not attractive to investors and resulted in a lot
of litigation over broker claims involved in originating such products.
Compensation Abroad
Compensation concerns spread abroad during the subprime crisis. In April

2009 the European Commission recommended caps on corporate pay such
that severance pay would be limited to two years of fixed pay, a minimum of
three years would be required for options to vest, and most bonuses would
be paid on a deferred basis. The Group of Twenty also considered curbs on
executive pay at its meeting in London that month. A report prepared by its
Financial Stability Forum asserted that compensation paid to executives at
financial services firms should be based not only on profitability but also on
whether excessive risks had been taken in order to generate high returns.
The president of Barclays bank, Robert Diamond Jr., was paid $30 million
in 2007, despite some severe problems at that bank, which included a $3 bil-
lion writedown. The home and automobile of Sir Fred Goodwin, the former
CEO of the Royal Bank of Scotland (RBS), were vandalized on March 24,
2009. Shareholders then added insult to injury by voting against his retire-
ment package, which would have paid him $1 million per year. Goodwin
eventually agreed to give up half of his $1 million pension. However, more
controversy arose over the $16 million pay package of the bank’s new CEO,
Stephen Hester, so he agreed to defer a portion of that compensation. At that
point, the bank had received some $30 billion in government funds and had
been nationalized. A parliamentary committee criticized bank executives at
both RBS and HBOS, which had also been bailed out by the British govern-
ment, for their compensation arrangements.
Mervyn King, the governor of the Bank of England, refused a $500,000
increase in pay in 2008, attempting to set an example for bankers in the UK.
Sir David Walker, a former Morgan Stanley executive, issued a report in July
2009 for the UK government recommending that corporate compensation com-
mittees be required to review executive pay at above-average levels and that
such pay be publicly disclosed. Sir David further recommended the creation
of board of director committees to assure that undue risks are not incurred.
However, one executive was quoted as saying, “Risk should be managed by
executives hour by hour, not by non-executives month to month.”15 Another
called the proposal a Sarbanes-Oxley look-alike and noted the failure of that
legislation in the United States.
The Financial Services Authority (FSA), London’s financial services regula-
tor, warned companies against the use of multiyear guaranteed bonuses during
the subprime crisis. Instead, the FSA wanted bonuses to be aligned with risks

incurred by executives and applied that requirement to twenty-six of the coun-

try’s largest banks. This was a new approach to the alignment of shareholder
and executive interests. Previously, reformers had focused on share prices to
align those interests, which gave rise to options as compensation and caused
scandals as executives manipulated their accounts to increase share prices.
The subprime crisis refocused reformers’ attention on risk, rather than share
prices, which were the focus of earlier reforms. They sought to give incentives
to executives to avoid undefined excessive risk.
The FSA later dropped a proposal that would have required deferring two-
thirds of bonuses and tying bonuses to group performance. It also announced
in August 2009 that it might have to back off its requirement tying bonuses
to risk because of concerns that it could hurt London’s standing as a financial
center. The banks soon attempted to game the system to keep other firms from
poaching their star traders. JPMorgan complained to the FSA in August 2009
that a compensation package offered by Barclays Capital (BarCap) in order
to grab a high-powered team of JPMorgan traders was excessive. Five traders
were offered a package valued at $50 million to join BarCap, which had also
distributed two-year guaranteed bonuses.
The risk-avoidance regulatory approach caught fire around the world. Ger-
many’s financial regulator, Bundesanstalt für Finanzdienstleistungsaufsicht
(German Federal Financial Supervisory Authority, or BaFin), announced in
August 2009 that German banks would be required to avoid compensation
plans that encouraged undue risk taking or that rewarded short-term profits.
BaFin also required increased stress-testing of positions at all levels, tightened
risk management controls, and directed that bank supervisory boards be given
greater control over management. In October 2008, Germany and Sweden
limited compensation for executives working at banks receiving government
aid and guarantees. Germany limited compensation to about $670,000 for
executives at its bailed-out banks.
In Switzerland, restrictions on bank compensation took an interesting twist.
The Credit Suisse Group dumped $5 billion of its toxic assets into a fund that
was to be used as a bonus pool for 2,000 of its executives for their work in
2008. This was called an “eat your own cooking” bonus plan. The bank reported
in August 2009 that this pool of assets had increased in value by 17 percent,
and that number increased to 72 percent in February 2010. This indicated that
those assets had been unnecessarily written down to fire-sale prices during
the crisis. Credit Suisse did revise its compensation scheme to add more of a
salary component, with bonuses split between cash and stock that would vest
over four years and be subject to clawbacks.
French prime minister François Fillon advised French banks not to hand
out large bonuses to its employees in 2009. The banks had previously agreed
to limit their bonuses as a condition of receiving $28 billion from the French
government as a bailout, and stock option grants were prohibited. The banks
agreed to tie their pay to profit, rather than revenue, in order to reduce incen-

tives for undue risk taking. Bonuses were to be paid over a three-year period,
with forfeiture of the unpaid amounts if a trader lost money in the two-year
period after the bonus year. However, BNP Paribas announced a $1.4 billion
bonus pool for 2009. This made the prime minister angry because that bank
had received a $7 billion bailout from the French government.
France had other compensation problems. French workers held Luc Rous-
selet, the manager of a 3M factory, captive in March 2009, demanding better
severance benefits for planned layoffs. Similar action was taken at a Sony
facility and at a Caterpillar plant in France. French president Nicolas Sarkozy
then vowed that he would end “boss napping,” but workers responded to
that challenge by taking managers of a British firm hostage. Other French
workers facing layoffs threatened to blow up the plants where they worked,
unless they were given increased severance pay. Workers at New Fabris, an
auto supply company, wired gas canisters to an electrical cable and threatened
to detonate them, unless they received $40,000 in severance payments from
Renault and PSA Peugeot-Citroën, New Fabris’s principal clients. The work-
ers were outraged because those auto companies had received $8 billion from
the French government as a bailout in exchange for promises not to engage
in mass layoffs of their autoworkers. However, that promise did not extend to
auto suppliers like New Fabris.
The Australian government announced in March 2009 that it planned to ad-
dress executive compensation issues and limit excessive “golden handshake”
termination payments by amending its Corporations Act to require shareholder
approval for such payments that exceeded a specified level.
The Bottom Is Reached
The Market Decline
Stock markets around the world plunged on March 2, 2009. The Dow Jones
Industrial Average fell by 299.64 points that day, down to 6763.29, a level last
seen in 1997. The next day gold prices dropped to $912.90, while the price of
crude oil rose to $41.65 per barrel. President Obama suggested that it would
be a good time for investors to reenter the stock market “if you’ve got a long-
term perspective on it.”16 That turned out to be excellent investment advice.
The Federal Reserve (the Fed) and the Treasury Department announced
an expansion of the previously announced $200 billion Term Asset-Backed
Securities Loan Facility (TALF) to $1 trillion. This program made secured,
nonrecourse loans available to banks and commercial firms, including hedge
funds. The securities were permitted to be used for collateral for such loans
including securitizations of credit card debt, consumer loans, and student loans
with a triple-A rating. The use of the rating agencies as the arbiter of collateral
quality for these loans seemed a bit strange in light of the ongoing criticism of
the rating agencies’ failures in rating collateralized debt obligations (CDOs).

Moreover, because the loans were nonrecourse, the Fed would have to bear
any losses (above a small haircut in the form of excess collateral in setting
their loan value) in the event of a decline in the value of the collateral.
This incongruity did not escape the notice of Neil Barofsky, a former pros-
ecutor who was placed in charge of policing TARP bailouts. Referred to as the
“TARP cop” in the press, he criticized the use of rating agencies in a report
to Congress in April 2009, noting that their ratings had proved notoriously
unreliable. Credit market participants did not initially give the TALF program
an enthusiastic welcome. Not enough investors were interested in signing up
for it, so the program was reworked but still failed to attract much interest. A
principal concern was that, if investors made money from the program, they
might be criticized in the press and before Congress as the executives at AIG
had been.
TALF was initiated on March 19, 2009, with three significant transactions.
Nissan Motor Company and Ford Motor Credit Company sold more than $4
billion in bonds backed by auto loans, and Citigroup sold $3 billion in bonds
backed by credit card payments. Still, by the end of July 2009, the Fed had made
only about $35 billion in loans under this facility, a rather paltry drawdown
on a $1 trillion facility. Nevertheless, the program picked up in August with
borrowings reaching $77 billion and was being credited with having jump-
started the securitization market for consumer receivables. The government
extended the TALF program until March 31, 2010.
Some former Countrywide executives were under fire for forming the Pri-
vate National Mortgage Acceptance Company (PennyMac), which purchased
distressed mortgages and foreclosed, or restructured, the loans in order to
make them performing. In one transaction, PennyMac, which was funded by
the money manager BlackRock and the hedge fund Highlands Capital, bought
$560 million in distressed mortgages from the FDIC for $43.2 million. The
FDIC acquired those loans when it took over the failed First National Bank of
Nevada. PennyMac was allowed to keep from twenty to forty cents on every
dollar that it collected on the mortgages.
The Dow was down 25 percent for the year on March 5, 2009. Citigroup
traded below $1 per share on that day, leading to the New York Stock Exchange
(NYSE) temporarily suspending a rule requiring the delisting of securities that
traded under a dollar. The day before, Moody’s announced that it was putting
$100 billion in collateralized corporate loan obligations on a negative credit
watch for a likely downgrade. That credit watch applied to 3,600 tranches
of 760 issues. However, the highest rankings of those issues were excluded
from the review.
One survey reported that more than 10 percent of U.S. homeowners were
delinquent on their mortgage or in foreclosure in March 2009. On March 4,
2009, President Obama announced a new plan to aid homeowners having trouble
meeting their mortgage payments through a program that would modify the
terms of loans issued or guaranteed by Fannie Mae or Freddie Mac. That modi-

fication would include reducing mortgage interest rates to as little as 2 percent.

This program would not be available for mortgages in default or where the
mortgages were more than 105 percent of the value of the home, an amount later
increased to 125 percent. It was claimed that this program would be available
to one in nine homeowners, and it was forecast to cost $75 billion in taxpayer
funds. More assistance was planned for homeowners who had problems meet-
ing payments on their home equity loans and for those who borrowed the cost
of the down payment for their homes—“piggyback” loans.
President Obama, surprisingly, stated that he would consider a cut in the
corporate tax rate. However, that positive news was offset by a dispute over
a proposal that would allow bankruptcy judges to reduce summarily, “cram
down,” mortgage principal and interest payments in bankruptcy proceedings.
Such a provision, supported by Democrats in Congress, was included in a
congressional bill for the TARP bailout program in 2008, but was deleted in
the interests of gaining Senate approval to pass the bill.
Finance was stirring abroad. Bond issues by banks under government
guarantee programs in Europe had raised $367 billion by March 2009, and an
additional $630 billion was expected to be raised under such programs during
the remainder of 2009. The United Arab Emirates announced the purchase of
$10 billion in bonds from Dubai in order to assist that struggling government.
China’s exports shrank by 25 percent in February 2009. Taiwan’s industrial
production was down 43 percent, European production was down 12 percent,
and production in Brazil was down 15 percent. Economists forecast a 9 percent
decline in world trade in 2009.
The European Central Bank cut its interest rates from 2.0 to 1.5 percent,
and the Bank of England cut interest rates in March 2009 to a historic low
of 0.5 percent. The UK government also announced a $105 billion plan to
encourage bank lending.
Market Critics Emerge
Commercial credit markets froze up again in the second week of March 2009.
Creditors were concerned that they would be the losers in the event of a default
of a large company. Hysteria over economic conditions mounted in the press and
in the Obama administration. Some pundits predicted a Dow “5000” in March
2009, the obverse of the prediction of a Dow 36000 during the stock market
run-up in the 1990s. In a front-page article in the New York Times on March 12,
2009, the specter was raised of the Justice Department preparing broad-scale
prosecutions against mortgage market participants, in an Enron redux.17
Lawrence Summers, senior economic adviser to the president, told the Fi-
nancial Times that the view that capital markets were inherently self-stabilizing
had been “dealt a fatal blow.” He denied that government intervention in the
mortgage market had caused the crisis.18 The Financial Times also published a
series of reports on the future of capitalism, the first of which was called “Seeds

of Its Own Destruction.” That article mocked the Reagan era of deregulation,
compared the subprime crisis to the fall of communism, and correctly predicted
that the crisis would strengthen political control over the markets.19
Fed chairman Bernanke added to that debate on March 10, 2009, by asserting
that regulators needed broader powers, including increased capital requirements
for banks, restrictions on investments by money market funds, and powers to
resolve failed financial institutions through a windup procedure. The SEC fol-
lowed up on his desire for restrictions on money market fund investments by
proposing to limit the investment risks that could be incurred by money market
funds and requiring investments by those funds to be more liquid. However, the
SEC already had a rule on its books, Rule 2a-7, that regulated the investments
that money market funds could make. That rule did not prevent the Reserve
Primary Fund (RPF) from breaking the buck and setting off a market panic in
2008. Under the new SEC proposal, money market funds would be limited to
the highest quality investments, but this raised the question of how that status
would be determined, considering that the SEC proposed ending the use of
rating agencies as the basis for credit assessment. The ratings agencies had
certainly established their fallibility with respect to credit assessment. It also
appeared that the SEC was once again ineffective, since it had amended Rule
2a-7 in 1990 to address concerns over money market investments in commer-
cial paper,20 but the Reseve Primary Fund, nevertheless, broke the buck as a
result of investments in Lehman Brothers commercial paper.
Obama clashed with European leaders over the action needed to deal with
the ongoing global financial crisis at the Group of Twenty conference in London
in March 2009. His administration wanted spending to be increased to restart
economies, while European leaders wanted to concentrate on regulatory reform.
Japan supported the U.S. position. The unemployment rate in the European
Union at that point approached 10 percent. Nevertheless, Germany expressed
concern over the possible rise of inflation in the United States because of the
massive liquidity operations already under way and the spending programs
proposed by the Obama administration.
Mirek Topolanek, president of the European Union and prime minister of
the Czech Republic, charged on March 26, 2009, that Obama’s plan to fight
the subprime crisis was a “road to hell.” He contended that the United States
was simply repeating mistakes of the 1930s through stimulus packages that
did not work and through protectionist policies. Topolanek was himself in
a bit of a spot. His government had just received a vote of no confidence at
home, and he was forced to resign halfway through his six-month term as EU
president, a post that rotates biannually among EU members.
Market Volatility
Crude oil closed at $47.07 per barrel on March 9, 2009. That day, the Japanese
stock market fell to a twenty-six-year low. The Bank of Japan announced a

plan to issue $10 billion of subordinated debt from its large commercial banks
on March 17, 2009. Some business was going forward. Merck announced its
purchase of Schering-Plough for $41.1 billion in order to become less depen-
dent on drug research and development, a risk-avoidance measure. That merger
included $107.9 million in golden parachute payments to ten Schering-Plough
executives. Dow Chemical announced the same day that it would purchase
Rohm & Haas for $15.3 billion. Roche Holding, which already owned 66 per-
cent of Genentech, bought the rest of the firm at a price that valued Genentech
overall at $47 billion.
The stock market rallied on March 10, 2009, after Citigroup announced
that it had been profitable in January and February and looked forward to a
profitable quarter. That would be a change from its five previous straight quar-
terly losses totaling $37 billion. The Dow rose 379.44 points after that report,
closing at 6926.49. The Dow jumped 239.66 points on March 12, 2009, after
news that retail sales had fallen less than forecast in February. Bank of America
lent further support to the market by announcing that it did not expect to seek
more bailout money. The week ending March 13, 2009, was the best week
for the stock market since November 2008. It rallied from a twelve-year low
on March 9 to rise 597 points during the remainder of the week. Thereafter,
crude oil closed at just under $50 per barrel on March 17, 2009, and the Dow
rose by 178.73 points, reaching 7395.70.
The minutes of the Federal Reserve meeting on March 17 and 18, 2009,
revealed deep concern over the possibility that the economy would continue
to decline in 2009. The Fed announced on March 18, 2009, that it would buy
up to $300 billion in long-term Treasury obligations, and some $750 billion in
mortgage-backed securities and debt issued by Fannie Mae and Freddie Mac.
That would bring the Fed’s total purchases of Fannie Mae and Freddie Mac
securities to $1.25 trillion in the first three months of 2009. This announcement
caused the largest one-day drop in yield on Treasury securities since the stock
market crash of 1987. The ten-year Treasury note’s interest rate fell from 3
percent to 2.5 percent. The rate on thirty-year fixed mortgages declined to 4.75
percent. The Dow Jones Industrial Average rose by 90.88 points to 7486.58,
an increase of 14 percent from its March 9, 2009, low. However, the dollar
slid against the euro.
The Wall Street Journal pointed out that the $300 billion purchase of Trea-
sury securities by the Fed was undermining its independence from the Treasury
Department. That independence had been achieved in 1951 through an accord
negotiated by long-serving Fed chairman William McChesney Martin. Previ-
ously, the Fed had acted with the Treasury to keep interest rates low, so that
the financing of World War II could be achieved at a lower cost.21 The 1951
accord freed the Fed of that obligation and allowed it to focus on inflation and
employment. The March 2009 action by the Fed appeared to be a return to
the World War II practice in which it acted to keep government funding costs
low. Some savings were needed. The Congressional Budget Office forecast

in March 2009 that the budget deficit would be $2.3 trillion more than that
claimed by the administration.
A government debt auction in the UK on March 26, 2009, failed for the
first time in seven years. An auction by the U.S. Treasury the same day was
the subject of heavy bidding, suggesting continuing strong demand for U.S.
Treasury securities. Gold prices were on the rise again as the size of the gov-
ernment bailouts continued to grow in the third week of March. Indeed, “gold
parties” were being held in private residences to take advantage of high gold
prices. A gold buyer would attend the party to appraise and purchase jewelry
from the attendees.
In the first quarter of 2009, state government revenues fell on average 11.7
percent, the sharpest decline ever, and continued to decline. The governor of
Illinois, Patrick J. Quinn, who had replaced the disgraced Rod R. Blagojevich,
sought a 50 percent increase in that state’s income tax in order to meet a budget
shortfall. New York, New Jersey, and Maryland needed to increase taxes in
order to close their growing budget deficits. After much struggle, the California
legislature passed a budget with higher taxes, but voters in the state rejected
the tax increases on May 20, 2009. The legislature tried again, finally passing
a budget on July 21, 2009. But before doing so, the state ran out of money and
issued IOUs to creditors, which it called “warrants,” in lieu of cash. The City
of Philadelphia stopped paying its bills in July as a result of a budget crisis.
New York City and State were caught cheating on their Medicaid claims and
agreed to reimburse that system for $540 million in false claims. A growing
problem was the underfunding of state employee pension plans. The SEC
sued the State of New Jersey for misrepresenting the status of its funding of
such plans. Unlike its cases against corporations and their officers, the SEC
imposed no fine or other penalty in settling the case, and no public officials
went to jail.
Government Interference
On March 23, 2009, Treasury Secretary Tim Geithner announced a trillion-

dollar program to take toxic assets (renamed “legacy assets”) off the books
of financial services firms. Under this program, called the Public-Private
Investment Program (PPIP), private investor funds would be matched dollar-
for-dollar by the Treasury to purchase CDOs, and the Treasury would provide
additional funding in the form of loans on favorable terms. The government
would then share in the returns on the CDOs with the investor. The govern-
ment planned to initially fund this program with as much as $500 billion. The
Dow jumped by almost 500 points after this announcement.
The PPIP was met with enthusiastic approval on Wall Street after it was
first announced, but enthusiasm died as the government tried to manage firms
receiving bailout money. The FDIC dropped out of the program in May 2009.
Some banks sought to use TARP funds to bid on their own legacy assets under

the program, but it stalled because, as Geithner stated, “investors are reluctant
to participate.” On July 8, 2009, the Treasury Department announced that it
would scale back the program to $30 billion and would work with a group of
nine private investors to buy toxic assets. Only $3 billion was committed by
private investors to the program by the end of September 2009, growing to
$12.27 billion in the first week of October.
Forty-seven banks and S&Ls failed in the United States between January
2008 and March 2009. Fed chairman Bernanke appeared before a congressional
committee on March 24, 2009, to request legislation allowing the Fed to seize
nonbank financial institutions and liquidate (“resolve”) them just as would
be done for a failed bank. Bernanke asserted that the lack of such authority
prevented the Fed from liquidating AIG and prevented it from stopping the
controversial bonus payments to the AIG executives. That resolution authority
was passed in 2010.
President Obama met with the heads of fifteen of the largest banks at the
White House on March 27, 2009. Some of the bankers informed him that they
wanted to return the government funds that they had received in the bailout. The
president rejected those requests, stating that repayment would be permitted
only if the ongoing regulatory stress tests demonstrated that the banks were
healthy. The Senate requested that the Fed reveal the names of firms receiving
loans and what they were doing with the funds. Such disclosures had under-
mined the lending program of the Reconstruction Finance Corporation in the
1930s but, apparently, some lessons needed to be relearned.
The Treasury Department reported at the end of March 2009 that it still
had not disbursed $135 billion of the $700 billion available under TARP. That
situation changed on April 8, 2009, with the announcement that the Treasury
would supply insurance companies with funds under TARP, but details and
amounts were not disclosed. The Treasury Department was later criticized by its
inspector general for allowing insurance companies to qualify for TARP funds
by buying small thrifts. Geithner stated in an interview on April 5, 2009, that
as a condition of receiving TARP funds the federal government was prepared
to force out senior executives and board members of firms, if the government
concluded that they did not measure up to their jobs.
Economic News
The Dow closed at 7924.56 on March 26, 2009, an increase of more than 20
percent from its bottom earlier in the month. An increase of over 20 percent
was generally defined as establishing a bull market. However, the Dow closed
the first quarter of 2009 down 13 percent, the sixth straight quarterly decline.
More bad news arrived in April, when it was reported that March retail sales
had dropped by 1.7 percent and that auto sales continued their decline. Du-
rable goods orders declined by 0.8 percent in March, but that was less than
expected. The mobility of Americans continued to decrease in March 2009,

reaching its lowest level since 1962, when the population was about one-third
of the size it was in 2009.
In March 2009 the unemployment rate was 8.5 percent nationwide but
considerably higher in some states: in California, 11.2 percent; in Oregon,
12.1 percent; in North Carolina, 10.8 percent; and South Carolina, 11.4
percent. In order to boost the stock market, President Obama stated at a
press conference on March 24, 2009, that he was “beginning to see signs of
progress” in the economy. However, the economy had shrunk by 5.7 percent
(later revised to 5.5 percent) in the first quarter of 2009, less than expected but
still troublesome in light of the 6.3 percent contraction in the fourth quarter
of 2008. Those were the two worst back-to-back declines in more than sixty
years. Nevertheless, economists projected that the recession would be over
by September 2009.
Troubles continued abroad. In the eurozone the gross domestic product
(GDP) declined by 2.5 percent over the previous quarter. Japan suffered a
record drop in economic output in the first quarter. Merger and acquisition
(M&A) activity fell globally in the first quarter, but underwriting increased.
Canadian banks seemed to have recovered their strength and began to explore
M&A opportunities in the United States. U.S. firms engaged in little M&A
activity because of strains on their resources. However, Pulte acquired Centex
for $41.3 billion, creating the largest U.S. home builder. That merger was con-
sidered good news because it helped reduce overcapacity and indicated that
restructuring was under way in the housing market. KB Homes, which shifted
the focus of its building to smaller, more affordable homes, had a first-quarter
loss in 2009, but it was smaller than expected.
The 800,000 homes put into foreclosure in the first quarter of 2009 set a
new record. By then, 20 percent of all home mortgages were underwater. The
delinquency rate on FHA mortgages increased. Approximately 10.2 percent
of homeowners who received FHA loans in the first quarter of 2008 were
delinquent in repayment by at least sixty days. The overall delinquency rate
for FHA loans in February 2009 was 7.46 percent, up from 6.16 percent in
February 2008. Existing home sales fell by 3 percent in March 2009.
The median price of a home in the United States was $169,000 at the end
of March, down 14 percent from a year earlier. Auto sales fell by 37 percent
in March, but sales picked up in the last week of that month. Manufacturing
continued to decline in March, but at a slower rate. American consumers in-
creased their bank deposits by an additional $250 billion in the first quarter of
2009. That would normally be a favorable sign, but, under the circumstances,
it was another signal that consumers had cut back on their spending, which in
turn caused retail sales to decline in March 2009.
Commercial real estate securitizations raised concerns in the first quarter
of 2009. Between September 2008 and March 2009 their delinquency rate
had doubled, to 1.8 percent. The share of corporate loans considered troubled
increased to 7.75 percent at the end of March 2009, up from 4.1 percent in

March 2008. However, corporate profits rose in the first quarter of 2009, the
first such increase after six quarterly declines.
JPMorgan Chase reported a first-quarter profit of $2.14 billion in 2009
and announced that it would seek permission from the government to repay
its $25 billion in TARP funds, which its CEO, Jamie Dimon, referred to
as a “scarlet letter.” Goldman Sachs made a $1.81 billion profit in the first
quarter of 2009 and planned a $5 billion stock offering. Bank of America
reported profits of $4.2 billion for the first quarter of 2009, most of which
came from its Merrill Lynch unit. However, Bank of America’s stock plunged
after its announcement that it had reserved another $13.3 billion for credit-
loss exposure. Nonperforming assets increased, and credit card losses rose
to $1.7 billion.
Citigroup reported a first-quarter profit in 2009 of $1.6 billion, its first
quarterly profit in eighteen months. However, some of its more important
units still experienced losses. General Electric also posted a profit in the first
quarter, but it, too, still struggled. Morgan Stanley rocked the market with a
larger-than-expected loss of $177 million, which followed a $2.3 billion loss
in the previous quarter. The company cut its dividend by 81 percent.
UBS experienced a first-quarter loss of $1.8 billion. The bank stated that
it was cutting costs by 15 percent, which included the elimination of 7,500
jobs. Deutsche Bank had a profitable quarter, reporting a $1.55 billion profit,
but its stock price fell due to concerns over its capital adequacy. Nomura
Holdings, Japan’s largest brokerage firm, reported a first-quarter loss of $7.3
billion as a result of trading losses and costs associated with its acquisition
of Lehman Brothers’ international operations. Nomura was also expanding
its presence in New York. Credit Suisse had a surprising $1.7 billion profit
for the quarter.
AIG was stung, again, by a first-quarter loss, this time totaling $4.4 bil-
lion, its sixth quarterly loss in a row. General Motors reported a $6 billion
loss for the quarter, while Ford lost $1.4 billion. Microsoft experienced a 32
percent decline in profits in the first quarter of 2009, the first such decline
in its history as a public company. American Express reported a 56 percent
decline in profits in the first quarter, but it was still able to post a $437 mil-
lion profit. Berkshire Hathaway’s first-quarter profit declined by 10 percent,
and the firm posted a loss of $1.5 billion. CIT Group had a $438 million loss
for the quarter, the eighth loss in a row, and more losses were anticipated
in the future.
The net income of the Federal Home Loan Banks (FHLB) declined by 51
percent in the first quarter of 2009. Fannie Mae lost $23.17 billion during the
quarter and sought an additional $19 billion from the federal government.
Freddie Mac lost $9.85 billion in the first quarter and needed $6.1 billion in
aid. On March 31, 2009, the Treasury Department extended its guarantee for
money market funds from April 30, 2009, through September 18, 2009, its
one-year anniversary, in the last extension of that program.

Sunrise in America
The Second Quarter Begins
The Group of Twenty meeting in London was held, appropriately, on April 1,

2009—April Fools’ Day. Anarchist demonstrators attacked the Bank of Eng-
land and broke into the Royal Bank of Scotland, but were eventually repelled
by riot police. President Obama admitted that the United States bore some
responsibility for the worldwide financial crisis, but made little headway with
European heads of state over his desire for larger stimulus programs. European
leaders continued instead to advocate more regulation. The Group of Twenty
agreed to work together to restructure national regulatory systems in such a
way as to take account of systemic, prudential risk. They further agreed to
implement new principles on corporate executive compensation, to promote
corporate responsibility, to regulate the credit rating agencies and hedge funds,
and to improve bank capital requirements. The representatives attending that
event agreed on a set of principles for regulating financial markets. A new
Financial Stability Board (FSB) including all Group of Twenty countries and
the European Commission was created to replace the existing Financial Stabil-
ity Forum that was composed of regulators from significant financial centers.
The FSB would work with the International Monetary Fund (IMF) to provide
early warnings of macroeconomic risk.
The European Central Bank (ECB) cut its interest rate to 1.25 percent on
April 2, 2009, and signaled that another cut could be expected. This was another
case where the principal central banks were not coordinating their monetary
policies. The Dow nearly reached 8000 that day, after the Financial Accounting
Standards Board (FASB) announced relief for banks from fair-value account-
ing requirements, and some glimmers of good news in the economy emerged.
However, jobless claims continued to increase, and the office vacancy rate
reached 15.2 percent. A Chrysler stable value fund that was designed to profit
even in adverse market conditions in 401(k) accounts, announced on April
2, 2009, that its value had declined by 11 percent. That announcement raised
concerns over other stable value funds, which constituted a $520 billion market.
However, those funds seemed to stabilize in August 2009.
The Dow posted its fourth straight weekly gain in the week ending April
3, 2009, to close at 8017.59. That gain came despite an employment report
of an additional 663,000 jobs lost in March; this brought the total number of
jobs lost during the recession to 5.1 million and pushed the unemployment
rate to 8.5 percent, the highest rate since 1983. Gold prices fell to $871.50
per ounce on April 6, 2009, after market optimism rose following the Group
of Twenty meeting.
As April 2009 began, HSBC raised $18.5 billion in a rights offering, which
set a new record for such offerings. However, the same month Swiss Re an-
nounced the elimination of 1,000 jobs, or about 10 percent of its staff. Lending

by banks slowed in March and April 2009, even though cash on hand at banks
had tripled from the levels of one year earlier. Berkshire Hathaway was the
subject of a credit downgrade by Moody’s on April 8, 2009, losing its triple-
A credit rating. Fitch ratings did the same a month earlier because of large
unhedged market exposures. Some good news emerged in the second week
of April, when a report on wholesale inventories indicated that they had been
further reduced in March 2009, the sixth straight month of such reductions.
Germany reported on April 9, 2009, that it would buying all outstanding
shares of the Hypo Real Estate Holding group. The largest shareholder in that
organization was J. Christopher Flowers, an American private equity investor,
who owned 21.7 percent of Hypo. Unemployment in Spain rose to 17.4 percent
in April 2009, raising concerns with its finances. The UK economy contracted
in the first quarter to a degree not experienced in more than thirty years and
did the same in the second quarter. The government of Hong Kong stated, in
April 2009, that it expected the worst economic conditions that year since the
conclusion of World War II. The Chinese economy as a whole, however, ap-
peared to improve, assisted by a $585 billion stimulus package. In Russia the
economy saw improvement as well. Japan announced a $154.6 billion stimulus
package on April 9, 2009, in order to boost its long-lagging economy.
The Dow Jones Industrial Average jumped by 246.27 points on April 9,
2009, closing at 8083.38. That rally was driven by better-than-expected results
from Wells Fargo, which posted a record $3 billion gain in the first quarter of
2009, a 50 percent increase in net income, attributed to its Wachovia opera-
tions. Still, bad news flowed. The number of recipients of jobless benefits
in the United States rose to over 6.1 million in the week of April 11, 2009.
General Growth Properties, the second-largest U.S. mall owner, with 200
malls, declared bankruptcy in mid-April after it was unable to refinance $3.3
billion in maturing debt.
A study by Standard & Poor’s in April 2009 estimated that 45 percent of
outstanding privately issued subprime debt would become nonperforming. The
rate for outstanding Alt-A debt, totaling $745 billion, was 31 percent, while that
for the $406 billion in prime debt was 7 percent. Citigroup, JPMorgan Chase,
and other mortgage servicers were given some $10 billion by the Treasury
Department for mortgage loan modifications in April 2009. Applications for
mortgage refinancing tripled in April 2009 over the level of a year before.
TARP Cops
On April 13, 2009, Herb Allison, the CEO of Fannie Mae, was selected by
President Obama to head the Office of Financial Stability, the office with
overall responsibility for TARP. Meanwhile, the head of Freddie Mac, David
Moffett, had resigned in March and was not replaced until July 2009, when
Charles Haldeman Jr., a former mutual fund executive, was appointed. This
left Fannie Mae and Freddie Mac without CEOs. Because of the controversy

over bonuses and government interference in firms receiving bailout money,

the government was having trouble filling executive slots. Congressional witch
hunts against executives also complicated the task. CFO jobs were particularly
hard to fill because these individuals were the first to go to jail if the company
ran into a problem. Financial institutions were also becoming wary of any
further participation in government bailout programs for the same reasons.
That situation was worsened by stories in the press about Neil Barofsky, a
former prosecutor placed in charge of policing the TARP bailouts. Referred to
as the “TARP cop” in the media, Barofsky in April 2009 investigated whether
any banks had cooked their books in order to qualify for TARP funds. Goldman
Sachs had not requested the funds in the first place and now sought permission
from the government to repay its TARP funds.
April 15, 2009, was a good day for the market. The Dow surpassed 8000,
two initial public offerings (IPOs) came to market, and the junk bond market
rallied. The cost of borrowing for junk bond–category borrowers fell in April,
leading to a number of new junk bond issues. However, the stock market re-
mained volatile. The Dow declined by 289 points on April 20, dipping under
8000 and ending a six-week market rally. Crude oil prices fell to $45.88 per
barrel on that day.
The IMF issued a less-than-optimistic statement on April 22, 2009, that the
world was in the midst of the worst global recession since the Great Depres-
sion. It forecast a 1.3 percent contraction of the global economy in 2009 and
only slow growth in 2010. The Organization for Economic Cooperation and
Development (OECD) predicted a decline in the world economy in 2009 of
2.75 percent. Europe expected a 4 percent contraction of its economies, while
the United States anticipated shrinkage of 2.8 percent.
The European Union approved a plan by the UK government to offer $72.5
billion in guarantees to banks underwriting mortgages and securitizing them
through CDOs. The European Union also approved, on April 23, 2009, rules
regulating credit rating agencies. Among other things, the rating agencies
were required to disclose their rating methodologies, to differentiate ratings
on complex products, and to hire at least two more independent directors.
The Italian government seized assets totaling $300 million from UBS, JP-
Morgan Chase, Deutsche Bank, and Defa at the end of April 2009, after a Milan
prosecutor charged that they had refinanced a $2.2 billion municipal offering
that was coupled with swaps. The prosecutor claimed that the refinancing did
not effect a saving, a condition for refinancing municipal debt under Italian
law, and that the banks had made $130 million in profits from the deal.
Job claims in the United States fell in the last week of April 2009. The
number of claims for the month was 491,000, down from 708,000 in March.
The employment rate was at 8.9 percent in April, and Fed chairman Bernanke
doubted that it would reach 10 percent. Manufacturing activity continued to
slow in April 2009, but at a declining rate, and consumer confidence was
up. Durable goods orders actually rose 1.9 percent in April. The Conference

Board’s index of leading indicators rose by 1 percent during the month. How-
ever, retail sales were down 0.4 percent from the year before. Capital One
Financial reported increased credit card losses in April.
Housing starts, as a whole, fell by 12.8 percent in April 2009 over those in
March. This was the lowest number of starts since 1959, but there was some
good news—single-family construction rose by 2.8 percent in April. In addition,
existing home sales rose by 2.9 percent during that month. Mortgage refinancing
increased as interest rates declined, resulting in projected savings of $18 billion
to homeowners. However, money market rates were also at a record low.
The Dow jumped 168.78 points on April 30, 2009, closing at 8185.73. It
was up more than 7 percent for the month. The stock market was up 34 percent
from the low that it reached in March 2009. Hedge funds were up on average
4.2 percent in the first four months of the year. Business investment, however,
was still anemic. Stockbrokers left the market in droves. Over 11,600 brokers
gave up their registration in the first four months of 2009. The highest number
of exits previously was in 2002, when the total for the year was 11,500.
Congress passed a $3.5 trillion budget for the 2010 fiscal year, but the
Senate balked at passing legislation that would allow judges to adjust (“cram
down”) mortgages in foreclosure. The number of foreclosures increased in
April to 342,000, up 32 percent from April 2008. Some 30 percent of resi-
dential mortgages were underwater. The pick-a-pay mortgage loans, which
allowed borrowers to choose the amounts of their monthly payments, were
suffering the highest delinquency rates. About 37 percent of such loans were
delinquent, and about 20 percent were in foreclosure. That compared to a 34
percent delinquency rate and a 14.5 subprime foreclosure rate on subprime
mortgages with more conventional terms.
Wachovia, which had been rescued by Wells Fargo, put $115 billion of pick-
a-pay mortgages onto its books. JPMorgan was holding $40 billion from such
mortgages as a result of its rescue of Washington Mutual. The FHA supported
the subprime market and guaranteed nearly 33 percent of all new mortgages,
up from 2 percent in 2006. Almost 20 percent of its subprime mortgages were
delinquent or in default in May 2009.
TARP Funds
A survey of banks receiving TARP funds found that more than 80 percent
used some of those funds to make loans, over 40 percent also used them to
bolster capital, and over 30 percent used them for investments and acquisi-
tions. The government’s stress test results for U.S. banks were disclosed on
May 7, 2007. Bank of America was found to need $33.9 billion in additional
capital, Wells Fargo required $13.7 billion, GMAC $11.5 billion, Citigroup
$5.5 billion, and Morgan Stanley $1.8 billion. Those not needing additional
capital included JPMorgan Chase, Goldman Sachs, Bank of New York Mel-
lon, and American Express.

Critics noted that the government had weakened its stress tests in response
to demands from the banks that were tested. Among other things, the banks
were allowed to value distressed CDOs by cash flow, rather than marking
them to market. Nevertheless, the test results seemed to have restored the
market’s confidence in financial institutions. After the results were announced,
the Dow rose to 8512.28. Several investment banks—including Goldman
Sachs, JPMorgan Chase, Morgan Stanley, Bank of New York Mellon, State
Street, and U.S. Bancorp—then officially notified the Treasury of their desire
to repay TARP funds.
Morgan Stanley responded quickly to the government’s demand that it
increase its capital, raising $9.2 billion by May 20, 2009. Wells Fargo also
raised $7.5 billion in equity on June 1. Bank of America raised $7.3 billion on
May 12 by selling a portion of its holdings in the China Construction Bank.
Temasek Holdings, the Singapore sovereign wealth fund that had invested
about $6 billion in Merrill Lynch before its rescue by Bank of America, was
given a 3.8 percent stake in Bank of America in exchange for Temasek’s Merrill
Lynch holdings. Temasek sold that stock in May 2009, taking a loss estimated
at $2 billion. However, Bank of America was able to raise nearly $33 billion
in capital during May and early June.
In May 2009 Bank of America announced the hiring of some 6,000 new
employees to handle a flood of mortgage refinancings that had been touched
off by falling interest rates, which were below 5 percent for thirty-year fixed-
rate mortgages in mid-month. The fact that no-doc and low-doc loans were
abandoned, and credit standards tightened, meant that more manpower was
needed to review applications. Government pressure led to the removal of
Bank of America’s chief risk officer, Amy Woods Brinkley, and four directors
resigned from the bank’s board and were replaced with directors experienced
in banking. In a sign of the times, two of those new directors were former
bank regulators.
The government added another hurdle for repayment of TARP funds on June
1, 2009, requiring all banks seeking to repay the funds to raise more capital
from private investors, even if the stress tests indicated that they had no need
for additional capital. JPMorgan Chase and American Express objected to
this requirement because they had both passed the government’s stress tests.
Nevertheless, the bank regulators insisted that they prove their ability to raise
additional capital, so both companies made equity offerings. JPMorgan Chase
raised $5 billion and American Express raised $500 million. In all, the largest
nineteen banks increased their capital by $85 billion in May and early June
2009.
Citigroup raised $5.5 billion by May 20, allowing it to meet its stress test
shortfall. In response to government pressure, Citigroup shook up its manage-
ment team again on July 9, 2007. Chief financial officer Edward Kelly, who
had been on the job for only four months and was Citigroup’s fifth CFO in as
many years, was removed at government insistence because of dissatisfaction

over his work. Citigroup was still struggling, but bank officials worked on a
strategy to avoid government pay caps by increasing base salaries by 50 percent
and by issuing large amounts of stock options to employees, who had seen their
Citigroup holdings plunge in value by 84 percent. They would have to share in
the bank’s equity with the government, which took down its 34 percent stake in
Citigroup in June 2009. JPMorgan and Bank of America also looked for ways
to increase employee pay without setting off another political firestorm.
The government continued to intrude on the management of financial
services firms receiving TARP funds. The head of the FDIC, Sheila Bair,
pressured Citigroup to reorganize its top management and sought to impose
more regulation over the bank. She wanted to replace Citigroup’s CEO,
Vikram Pandit, who had an investment banking background, with a commer-
cial banking team. However, the Fed and the Treasury Department were not
convinced that this was necessary. Bair also wanted to downgrade Citigroup’s
regulatory rating, which caused it to delay converting preferred shares into
common shares in a capital-raising effort. Bair lost on that issue as well, and
the conversion proceeded in June 2009. The regulators did force Citigroup
to hire outside consultants to determine whether its current management was
capable of leading the bank.
Ten banks—including JPMorgan Chase, Morgan Stanley, Bank of New
York Mellon, Goldman Sachs, State Street, American Express, and BB&T—
were allowed to repay their TARP funds to the federal government on June 9,
2009. All told, those ten banks repaid $68.3 billion of the $239.4 billion that
had been injected into financial institutions by TARP. The government earned
$1.8 billion in dividends from the ten banks.
The government anticipated additional profit of around $4 billion from war-
rants received from these banks as a condition for receiving the funds. Banks
repaying their bailout funds then tried to buy back the warrants, but the Treasury
Department demanded an unrealistic price. This angered the banks, some of
which had taken TARP funds only because the Treasury Department had asked
them to do so in order to avoid stigmatizing banks, like Citigroup, that really
did need the funds. As Jamie Dimon, CEO of JPMorgan Chase, stated, his
bank “didn’t ask for it, didn’t want it, didn’t need it.”22 Indeed, JPMorgan had
raised $11 billion in September from a stock offering in private markets.
Morgan Stanley repurchased its warrants from the government for $950
million in August 2009, giving the government a total return of $1.27 billion
for its $10 billion bailout of Morgan Stanley, an annualized return of some 20
percent. Goldman Sachs repurchased its warrants for $1.1 billion, and Bank
of New York Mellon paid $136 million to repurchase its warrants.
Green Shoots
May Day celebrations in Europe turned into widespread protests over economic
conditions, in which hundreds of thousands of demonstrators participated.

The demonstrations were mostly peaceful, and there was reason for protest.
Eurozone industrial production had fallen by 20 percent in the previous twelve
months. Standard & Poor’s placed the United Kingdom on a credit watch in
May, signaling a credit downgrade in its triple-A rating because of its eco-
nomic problems. This resulted in a sharp drop in the price of UK obligations
and increases in its funding costs. Emerging markets bounced back, however,
increasing in early May by 50 percent over their March 2009 lows.
The banks tightened the terms of their lines of credit, which were often the
last resource for firms experiencing liquidity problems. The United States is-
sued some $10 billion in TALF bonds on May 4, 2009. The Federal Reserve
created a loan program in May, to be launched in June 2009, which was
intended to aid commercial real estate lending. The loans had terms of up to
five years and were to be used to buy bonds backed by commercial real estate.
Help was needed. The number of commercial mortgages at risk of default had
quintupled in the first four months of 2009, at a value rising from $4.6 billion
to $23.7 billion. Standard & Poor’s was causing confusion in the commercial
mortgage-backed market in July 2009 by flip-flopping on the ratings it gave
to certain issues. It first rated them triple-A, then downgraded them, and then
restored the rating. The rating agency said the restoration was due to changes
in its rating criteria.
As May began, new job claims fell and productivity was up. Crude oil
prices rose once again, reaching $58.63 per barrel on May 8, 2009. The gov-
ernment reported, in May 2009, that the budget deficit widened by another
$90 billion, to total $1.8 trillion. A study determined that the Medicare fund
would be exhausted by 2017, two years earlier than previously projected.
Social Security was forecast to be bankrupt by 2037, four years earlier than
had been projected just one year earlier. The federal government spent more
than $1 trillion on Medicare and Social Security, which together comprised
about a third of the budget in 2008.
Jean-Claude Trichet, president of the European Central Bank, speaking
on behalf of central bankers around the world, declared on May 11, 2009,
that the global economic downturn had bottomed out around the world in
March, except for the United States. However, Fed chairman Bernanke
testified before Congress on May 5, 2009, expressing guarded optimism on
the recovery of the economy. Bernanke stated that the Fed was seeing signs
of “green shoots” in economic growth, and those words echoed around the
world. The National Bureau of Economic Research concluded in 2010 that
the Great Recession actually ended in June 2009. The economy did appear
to be recovering, but it was not assisted by the stimulus package passed by
Congress in February. About $45 billion had been given to the states from
that package to cover Medicaid costs and jobless benefit claims. Only about
$11 billion had been spent on “shovel-ready” highway projects, which were
supposed to be the heart of the stimulus package economic recovery program
and few jobs were created.

The Struggle Continues
New credit card legislation was passed in May 2009 that restricted the ability
of credit card companies to increase interest rates on existing balances and
required more disclosures on fees. It prohibited automatic fees on cardhold-
ers who exceeded their spending limits. Instead, cardholders would have to
be given notice of the breach and fee, so that they could decide not to use the
card in the future. This legislation was directed at the high charges placed on
subprime credit card holders. President Obama signed that legislation even
though it carried a provision allowing the right to carry firearms in national
parks, a proposal demanded by Republicans for allowing the legislation to
pass. Citigroup responded to that statute by sharply raising its fees in advance
of the effective date of that legislation—2010. By November 2009, Citigroup
charged 29.99 percent in interest for credit card balances. Bank of America also
announced that it would be eliminating free checking services in order to make
up for the revenue lost from this legislation. The legislation thus backfired,
causing only more expense to cardholders. Concern over provisions in this
legislation on customer remedies also caused two large arbitration bodies to
withdraw from hearing further credit card claims that consumers were lodging
against their credit card companies. This legislation came at an inopportune
time for the credit card companies, which faced increasing credit card default
as unemployment rose and the recession deepened.
The Florida BankUnited failed on May 21, 2009, which was expected to
cost the FDIC $4.9 billion. BankUnited was the thirty-fourth bank to fail in
2009, compared with twenty-five in all of 2008. The FDIC arranged to sell
BankUnited to a group of private equity investors that included the Carlyle
Group and the Blackstone Group, which contributed $900 million in equity
to the bank in exchange for its assets. The FDIC agreed to assume 80 percent
of the first $4 billion of losses at the bank and 95 percent of any additional
losses. It raised its fees on larger banks on May 22, 2009, in order to increase
its insurance fund by $5.6 billion. This met some objection considering that it
was the failure of smaller banks that was draining the FDIC’s insurance fund.
However, FDIC chair Sheila Bair scoffed at those objections, noting that the
larger banks had been bailed out with a massive infusion of taxpayer funds
through TARP.
The Dow Jones Industrial Average rose to 8473.49 on May 26, 2009, after
a report of the first increase in consumer confidence in eight months. The
Dow was then some 30 percent higher than in March, but it was still down
3.5 percent for the year. Hedge funds gained 5 percent overall in May 2009.
BMW sales were down 18 percent in May from the prior year, and Mercedes
sales fell 12 percent. Crude oil sold at $62.45 per barrel. The spread on the
yield curve for two- and ten-year Treasury notes widened to 2.75 percent on
May 27, 2009, the highest ever.
Nonfarm payrolls lost 345,000 jobs in May 2009, raising the unemployment

rate to 9.4 percent. This was the highest unemployment rate in twenty-six years,
but it was the smallest monthly job loss since September 2008. Employment
actually increased in some states. Although the Fed’s Beige Book disclosed
further weakening in the economy in April and May, the trend seemed to
bottom out. New home prices also appeared to stabilize, and durable goods
orders increased in May.
A survey of 100 of the largest global financial institutions published in
June by the accounting firm Deloitte found that many financial institutions
still had not tightened their risk management controls. More than 40 percent
of those institutions were not stress-testing their structured finance portfolios.
German chancellor Angela Merkel launched an attack on central banks in the
United States and Europe on June 2, 2009, claiming that they were laying
the groundwork for another financial crisis. The following day, Fed chairman
Bernanke warned that the economy was in danger from the large deficits that
were accumulating.
General Motors declared bankruptcy on June 1, 2009, and was dropped
from the Dow Jones Industrial Average. The automaker was bailed out and
reorganized by the government’s “car czar,” with the government and unions
taking the lion’s share of what was left from that train wreck. At the same time
Citigroup was ejected from the Dow, with both firms replaced by Travelers
and Cisco Systems. Things looked slightly better for the automakers in June
2009, when sales declined by 28 percent. That was a lot, but it was the lowest
decline in five months.
On June 9, 2009, an auto parts trade group asked the federal government
for $8 billion in loan guarantees for its members. Later, in July 2009, the
Pension Benefit Guaranty Corporation took over $6.2 billion in liabilities of
the pension fund of the bankrupt automotive parts firm Delphi. The Delphi
pension plan had a total deficit of $33.5 billion. It sold its remaining assets to
creditors and to GM. Adding uncertainty to car demand, the price of crude oil
exceeded $70 per barrel on June 5, 2009.
The interest on an average thirty-year fixed-rate mortgage rose to 5.79
percent on June 10, 2009. It was expected that recent increases from the less
than 5 percent interest rate level for thirty-year mortgages, which had been
available at the end of May, would cut refinancings in half. The government-
sponsored enterprises (GSEs) took on most of the new mortgage risk. Govern-
ment National Mortgage Association (Ginnie Mae) issued a record $43 billion
in mortgage-backed securities in June 2009. The FHA’s overall default rate
reached 7 percent of its insured mortgages, and the overall delinquency rate
rose to 13 percent. It was insuring $560 billion in mortgages, four times the
amount only three years earlier.
The Dow rose to 8799.26 on June 12, 2009, putting it into positive territory
for the year. However, the Dow suffered a setback on June 16, 2009, falling
by 187.13 points, returning it to negative territory. The rise in the stock market
was bringing back “reverse convertibles”—bonds that paid high rates but that

then converted into stocks after the share price dropped to a preset level. Such
securities had suffered large losses in 2008, as the market plunged. Financial
engineers tried to repair flaws in the auction rate securities market by creating
an instrument that would require the borrower to repay the principal of the
securities within a specified period after an auction failed.
Goldman Sachs agreed to pay $60 million to Massachusetts in order to settle
claims over its subprime securitizations. Of that amount, $50 million was to
be used to reduce the principal due on subprime loans that were securitized.
KB Homes reduced its losses and announced an improvement in house sales in
June 2009. Its stock price had fallen by about 70 percent during the subprime
crisis. However, the company was forced to enter into a deferred-prosecution
agreement with the Justice Department on July 1, 2009. The company admitted
that it had charged illegal fees in its home sales and made “gifts” to purchasers
that were used for down payments on mortgages. Those gifts were recouped
by increasing home prices. KB Homes agreed to pay $50 million in restitution
to homeowners.
The OECD concluded, on June 24, 2009, that the worldwide economic
slump had reached bottom. This added to a growing number of such reports.
Nevertheless, that day the ECB injected €622 billion into banking institu-
tions in Europe as a stimulus measure. The Fed, at the same time, expressed
the view that the U.S. economy was likely to remain weak for some time.
It stated that it would maintain interest rates at zero for an extended period
of time. It also announced that it would proceed with its plan to buy up
to $300 billion in Treasury bonds in order to infuse the system with more
liquidity and to drive down interest rates. The Fed continued with its plan
to buy $1.25 trillion in mortgage-backed securities, but declined to expand
that program further.
In the second quarter, GDP contracted at an annual rate of 1 percent, much
less than expected. Consumer saving was at its highest level since 1993, which
meant that consumer demand was still dormant. However, consumer confi-
dence increased for the fifth straight month. The unemployment rate stood at
9.5 percent on July 2, 2009. By then, some 6.5 million jobs had been lost as
a result of the subprime crisis. The Dow fell by 223.32 points after this news
was made public. Reports from the job market were, indeed, troubling. Jobless
benefit claims had continued to exceed 600,000 for more than twenty straight
weeks. The jobless situation was the worst in fifty years. Bank lending declined
by 2.8 percent in the second quarter at the fifteen largest banks.
A rogue trader hit the oil market on June 30, 2009, pushing crude oil prices
up by more than $2 per barrel. The trader was identified as Steve Perkins, who
worked at PVM Oil Associates, a large oil broker that lost some $10 million
as a result of his trading. In another strange turn of events, Italian authorities
arrested two Japanese citizens trying to smuggle $134 billion in U.S. govern-
ment bearer bonds into Switzerland in a false-bottomed suitcase. The bonds
turned out to be counterfeit.

Housing starts increased in June for the third month in a row. The gain in
sales of new homes in June 2009 was the highest in eight years, but it was still
21 percent lower than in the previous June. Those sales were being driven by
lower prices. The vacancy rate for apartments reached 22 percent at the end of
the second quarter. Toll Brothers announced the reintroduction of adjustable
rate mortgages that would begin with a low 3.75 percent interest rate and then
reset after seven years at 275 basis points over LIBOR (the London Interbank
Rate) with a cap of 8.75 percent.
Numerous executives at major companies sold their stock in the summer
of 2009, either a troubling sign of pessimism or an effort to cash in on a ris-
ing market. Investment banks were hard at work creating ways to avoid the
expected increases in regulatory capital. One proposal was to take bank assets
off the balance sheet by securitization (as if no one had tried that before), but
the twist added was a pooling of those assets from several banks.
Goldman Sachs created an asset insurance program similar to the UK gov-
ernment guarantee of bank assets but funded privately. British banks shunned
the government program because of its high costs. Subprime securitization
pools continued to dump foreclosed homes on the market at fire-sale prices in
July 2009. The pools sold several times the number of homes foreclosed by
banks, at prices lower than the banks were willing to accept. The securitized
foreclosures were also less likely to allow loan modifications that would keep
homes out of foreclosure.
Loan modification programs were lagging. Only 200,000 mortgages had
been modified in the government’s program by July. President Obama met with
a group of mortgage servicers in July 2009 and urged them to speed up loan
modifications. Treasury Secretary Geithner and the secretary of Housing and
Urban Development (HUD), Shaun Donovan, called another meeting of the
twenty-five largest mortgage servicers for July 28, 2009, in order to persuade
them to accelerate the pace of mortgage modifications. Foreclosures then oc-
curred at an annual rate of 3.5 million, up from 800,000 in 2005. A front-page
article in the New York Times charged that mortgage modifications were slow
because mortgage lenders received large late fees on delinquent payments.23
However, the Obama administration announced in November 2009 that one
in five of the 650,000 homes eligible for its Making Home Affordable pro-
gram benefited from mortgage modifications. Mortgage modifications did not
come cheap. Fannie Mae suffered over $7.7 billion in losses from mortgage
modifications in the third quarter of 2009. Yet as October began, only 116,000
mortgages had been modified under this program, now called the Home Af-
fordable Refinance Program (HARP).
Commercial loan defaults continued to increase and were expected to total
$30 billion by year-end 2009. The federal government lost $2.3 billion in
TARP funds as a result of the CIT bankruptcy, bringing total expected bailout
losses to $117 billion. Surprisingly, this amount was roughly equal to the
losses experienced during the savings and loan crisis in the 1980s, but the total

bailout cost for the subprime crisis was reduced even further in April 2010
to $89 billion. The bailout losses were concentrated mostly at Freddie Mac,
Fannie Mae, AIG, the auto industry, and the mortgage modification program.
Small community banks that accepted TARP funds were also having difficulty
repaying those loans. Anton Antonucci Sr., the CEO of the failed Park Avenue
Bank, was indicted for attempting to defraud TARP of $11 million.
The banks had repaid $173 billion in TARP funds by February 2010, the
federal government had made some $10 billion from those investments. The
government made another $1.32 billion after it sold 20 percent of its hold-
ings in Citigroup, reducing its ownership to 22 percent. Another sale in July
2010 reduced that interest to 18 percent and brought government profits to
$2 billion.
The Obama administration admitted on July 10, 2009, that it had been slow
in implementing the giant stimulus plan approved by Congress months earlier,
but Treasury Secretary Geithner told an audience in London three days later
that the economy was showing positive signs and that additional stimulus was
unnecessary. Notably, by then, the U.S. federal budget deficit topped $1 trillion
for the first time and was expected to double by year’s end. Nevertheless, the
worst of the subprime crisis appeared to be over. Minutes of the Fed’s meet-
ing in July showed optimism for a recovery but expressed concern over high
unemployment levels for an extended period. That concern was well founded,
as unemployment exceeded 10 percent in fifteen states in mid-July 2009.
Goldman Sachs reported its second-quarter results on July 14, 2009—$3.44
billion in profits, which was more than Goldman earned in all of 2008 and the
highest ever reported by the firm. The attention getter was the $11.4 billion set
aside for Goldman employee bonuses at year’s end. This announcement set
off another populist furor in Congress. Several members of Congress asked
the Fed to consider whether Goldman was too lightly regulated and whether
it was taking on inordinate risk to realize those profits.
JPMorgan had second-quarter earnings of $2.7 billion, an increase of 36
percent over the same quarter in 2008. Other financial institutions had large
profits from refinancing and from a recovery of their mortgage portfolio values
from the panic-driven writedowns of the previous year. BlackRock earned
large sums from its management of the government portfolio of troubled assets
from Bear Stearns and AIG. However, a scandal brewed over BlackRock’s
wooing of business from Charles F. Millard, the head of the Pension Benefit
Guaranty Corporation (PBGC). BlackRock and Goldman Sachs wanted to
manage more than $1.5 billion in PBGC funds. They were given contracts,
but those contracts were revoked after it was revealed that the firms had enter-
tained Millard at expensive places, like the Ritz-Carlton, before the contracts
were implemented.
It was revealed in the press on July 16, 2009, that both Bank of America and
Citigroup were operating under secret agreements with the FDIC to improve
their corporate governance by revamping their boards and increasing risk

controls. Citigroup had commissioned an independent review of the quality

of its management to satisfy the regulators. That study, completed in October
2009, found with a few exceptions that Citigroup managers were well quali-
fied. However, the FDIC was skeptical of the study’s methodology. In the
meantime, the large banks paid millions of dollars to attract high-producing
salespeople for bonds and other products. Both banks reported profits for the
second quarter, but those profits were due to one-time gains. Bank of America
warned of continuing difficulties as consumers struggled with the recession.
The Dow fell to 8146.52 on July 10, 2009, but rallied to 8331.68 on July
13, 2009. The price of crude oil dipped to just under $60 per barrel. The Dow
resumed its rise, closing at 8743.94 on July 17, 2009, after initial second-
quarter earning reports showed profitable gains by several firms. However,
General Electric’s earnings fell by 49 percent year on year, due to continuing
problems in its financial services unit. Credit card delinquencies declined.
Demand for loans from the Fed decreased in July, suggesting a recovery in
the credit markets.
The Way to Recovery
The Rocky Road
In testimony before Congress on July 21, 2009, Fed chairman Bernanke stated
that the economy continued to show signs of recovery. However, he cautioned
that high unemployment was likely to persist and, therefore, the Fed would
maintain interest rates at their current low levels. He also wrote in an op-ed
piece in the Wall Street Journal that the Fed would be alert to signs of infla-
tion that might be spurred by low interest rates and easy money at low rates.
Bernanke simultaneously conducted a public relations campaign to justify the
Fed’s bailout of the big banks. At a town hall meeting in Kansas City, Mis-
souri, Bernanke said that he had to “hold my nose” in making the bailouts,
especially with respect to financial institutions making “wild bets,” but did it
out of concern that the entire financial system could collapse.
Guaranty Financial Group, a large Texas bank, announced on July 24, 2009,
that it would restate its accounts and take a large writedown. The bank stated
that it expected to fail as a going concern. Microsoft announced its first-ever
fiscal year loss in July. General Motors saw its sales continue to decline, for
the sixth quarter in a row. Ford’s sales increased, and the firm even reported
a profit. The Dow exceeded 9000 on July 23, 2009, as second-quarter earn-
ings reports continued to be generally higher than expected at companies
like Amazon.com and 3M. The housing market also showed further signs of
strengthening.
International financial institutions were showing mixed results. Nomura
Holdings experienced a fiscal year-end loss of $7.45 billion. It continued to
encounter difficulty integrating the Lehman operations that it had purchased.

Deutsche Bank reported an increase in earnings of 68 percent for the second

quarter. HSBC Holdings beat analysts’ expectations with a profit of $3.35 bil-
lion in the second quarter. Barclays earned a similar amount. However, UBS
reported a $1.3 billion loss for that quarter. Lloyds had a $6.8 billion loss in its
first two quarters, but reported that its business was improving. In Germany,
Commerzbank continued to experience losses, reporting a second-quarter loss
of $1.8 billion. The Royal Bank of Scotland reported a loss of $1.7 billion for
the first six months of 2009. Credit Suisse reported a 29 percent increase in
earnings for the second quarter.
Berkshire Hathaway made a $3.3 billion profit for the second quarter, com-
pared with its first-quarter loss of $1.5 billion. AIG even reported a quarterly
profit for the first time in two years, but that profit was due mainly to accounting
changes and valuation adjustments. CentexCorp and Pulte Homes had mixed
results. They planned a merger, which would create the largest home builder
in the United States. Hedge funds had a good first half of 2009, with an aver-
age increase of 12.14 percent over the prior year.
Morgan Stanley reported disappointing earnings on July 22, 2009, having
lost $159 million in the second quarter. This was the third quarter in a row
that Morgan Stanley reported a loss. Unlike Goldman Sachs, Morgan Stanley
had taken a risk-adverse approach to recovery, which was the course dictated
by the government and corporate reformers. Wells Fargo made $3.17 billion
during the quarter, but its number of nonperforming mortgages increased by
45 percent over the prior year, totaling $18.3 billion. American Express ex-
perienced a 48 percent drop in earnings over the prior year.
Bank of America announced on July 27, 2009, that it would close 10 per-
cent of its 6,100 branches. Citigroup had a problem with two hedge funds
in its Citigroup Alternative Investments division: One $3.4 billion fund was
frozen by its investors after a number of deals fell through, and its co-head
quit; another Citigroup fund, one for sustainable development programs, could
not attract investors.
The Fed and the Treasury Department entered into memorandums of
understanding with hundreds of banks, that is, nonpublic agreements by the
banks to take corrective measures, such as boosting capital or strengthening
management. It was a further reflection that government regulators were taking
over many management functions at the large banks. Citigroup reconstituted
its board of directors as ordered by the government, adding three more new
directors on July 24, 2009.
In the last week of July the Treasury Department issued $200 billion in
debt to fund federal government spending. It was estimated that the FDIC
debt guarantee for debt issues of financial institutions would save those is-
suers some $24 billion in interest costs that they would have incurred absent
such a guarantee. The banks also made large profits from their trading with
the Fed and expected to realize fees of more than $38 billion in 2009 from
customer overdraft charges. However, the Fed later curbed fees on overdraft

charges, requiring the banks to obtain the permission of customers in advance

of charging them. The Fed also proposed restrictions on fees and expiration
dates for retail gift cards.
A Parting of the Clouds
A drumbeat of good news sounded as July ended. The Dow passed 9100
on July 27, 2009, driven by reports of a large increase in home sales. It was
reported on July 28, 2009, that between April and May 2009 housing prices
had risen for the first time in thirty-four months. The Fed disclosed on July
29, 2009, that its survey of regional economic conditions indicated that the
economy was stabilizing. July was the Dow’s best monthly performance in
almost seven years, and the number of job losses that month was the lowest
in nine months. President Obama responded to that news by saying, “We’re
pointed in the right direction.”
Toll Brothers reported a declining number of house cancellations and an
increasing number of orders for its lower-cost models. Its CEO made $50
million from stock sales during the year. Housing prices rose in July. The
lower end of the housing market rebounded in July, but the higher end was
still stalled. The delinquency rate on jumbo prime mortgages rose from less
than 1 percent in 2007 to more than 7 percent in July 2009. The delinquency
rate for ordinary prime loans was 6.4 percent in August 2009, while that for
subprime delinquencies reached 25 percent. Delinquencies increased on prime
mortgages.
State tax revenues fell by 17 percent in the second quarter. Nevertheless,
a feeling of elation was in the air as August began. The cash-for-clunkers
tax credit in the stimulus package brought customers back to the automobile
showrooms. The S&P 500 Index passed 1000 on August 3, 2009; the NASDAQ
climbed above 2000; and the Dow closed at 9286.56. Those rises were aided
by improved earnings reports from Tyson Foods and Pilgrim’s Pride.
Leveraged loan prices increased, which suggested that market was thawing.
The average bid on a leveraged-loan CDO increased to more than 90 percent
in August, the first time that level had been reached in over a year. American
Express experienced improved payments on its credit cards in August, but
high-end cardholders still did not spend at their customary levels. The U.S.
Postal Service lost $2.4 billion in the second quarter, but this attracted little
notice. The jobless rate fell to 9.4 percent in the first week of August, defying
expectations that it would increase, in the first drop in the unemployment rate
in fifteen months. The Dow jumped to 9370.07 after that news was released,
but the decline in unemployment was thought to be due to the fact that more
people had stopped looking for a job. In any event, stocks were up almost 50
percent from their bottom in March 2009.
The Fed announced on August 12, 2009, that it believed that the economy
had leveled out and that it planned to start phasing out its emergency programs.

It also stated that it would not complete its $300 billion asset purchase program
until October, a month later than originally planned. Economists asserted that
as of August the Obama stimulus package had had only a small effect on the
economy. It was also reported that the federal government sent 3,900 stimulus
checks of $250 to jailed criminals. The administration forecast that the federal
government would incur an additional $9 trillion in debt over the next decade,
while others claimed that it could actually be much higher.
KKR announced plans for six large IPOs of companies that it owned in
August 2009. Sovereign wealth funds returned to Western investments in the
third quarter, after withdrawing from the market as the subprime crisis peaked.
The China Investment Corporation, a sovereign wealth fund, invested $1 bil-
lion with Oaktree Capital Management, a hedge fund that planned to use the
money to invest in distressed debt. Distressed debt acquisitions increased.
Buying the distressed debt of a company and then using it to take control from
shareholders in a reorganization of the company was another popular program.
Some 140 such transactions were carried out in the first seven months of 2009
and were valued at $85 billion.
Productivity rose in the United States to its highest level in six years. A
survey of economists by the Wall Street Journal in August 2009 found that a
majority thought the recession had ended. Global conditions also seemed to be
improving. Germany and France reported increases in growth for the second
quarter, which took them officially out of recession, because they also had
growth in the first quarter. Manufacturing increased in the UK and Italy. China,
Indonesia, South Korea, and Singapore reported growth in the second quarter
exceeding 10 percent. Japan’s economy also showed signs of recovery. The
Swiss government sold its $6.5 billion stake in UBS on August 20, 2009. That
bailout proved to be a good investment for the Swiss government—it made a
profit of $1.13 billion from the sale, a 30 percent return on an investment that
lasted ten months. However, UBS had trouble extricating itself from a Swiss
government agreement guarantying some of its toxic assets. That arrangement
turned out to be a very expensive one for the bank
By August 16, 2009, the Dow had risen by 42 percent over its March 9 low,
closing at 9321.40, but it was still 34 percent below its October 2007 high of
14164.53. Electricity prices dropped sharply in the summer of 2009, providing
more relief for consumers. Still, problems persisted. Atticus Capital, a large
hedge fund, closed its doors on August 11, 2009, and announced the return of
$3 billion to investors. Colonial Bank, a large regional bank located in Mont-
gomery, Alabama, failed on August 14, 2009, in the sixth-largest bank failure
in U.S. history. Its assets were acquired by BB&T. As of August 16, 2009,
seventy-seven banks had failed for the year, and 102 banks had failed in the
past two years. The cost to the FDIC of those failures was about 10 percent
more than that of the bank failures in the 1990s.
Markets worldwide caught a case of the jitters on August 17, 2009. The
Dow fell by 186.06 points. Japan’s markets were particularly hard-hit, and

European markets also plunged. Readers Digest, a conservative American icon,

announced that it was declaring bankruptcy that day. Lowe’s also chose that
day to report a profit decline of 19 percent in the second quarter. Home Depot
later weighed in with an earnings decline of 7 percent for the quarter.
Credit card delinquencies declined, but that business had another problem.
Albert Gonzalez was charged with computer crimes associated with his hacking
into various company computers in order to steal credit card information from
130 million consumer files for use in identify theft scams. He had previously
been charged with stealing 40 million credit card numbers from TJ Maxx,
costing it $200 million. Gonzalez was already in custody on another charge,
which involved his hacking into the computers of Dave & Busters, a restaurant
chain. Gonzalez had two Russian accomplices.
A Fed survey in August of nineteen banks that had received bailout money
found that they had reduced their loan balances by 1 percent in June 2009.
They expressed a consensus view that lending would not pick up until the sum-
mer of 2010, attributing the lack of loan growth to tightened credit standards
and low demand. Nevertheless, Citigroup investors had cause to smile, as the
firm’s stock price had risen by 70 percent in one month.
Freddie Mac faced more losses, this time from dodgy loans issued by Taylor,
Bean & Whitaker Mortgage Corporporation, based in Ocala, Florida. That
company, the twelfth-largest mortgage lender in the country, became insolvent
in August 2009 due to the FHA’s revocation of its status as a mortgage origina-
tor that was qualified for FHA mortgage insurance coverage. The suspension
was caused by state regulatory actions and misrepresentations made by Taylor
Bean to the FHA concerning the decision of its auditor to discontinue its an-
nual audit. Fannie Mae stopped dealing with Taylor Bean in 2002 because of
concerns over its lending practices. However, Freddie Mac viewed this as an
opportunity to expand its portfolio and began buying Taylor Bean loans in
large amounts. The chairman of Taylor Bean was later indicted and charged
with perpetrating a fraud involving billions of dollars.
Ginnie Mae sold a massive amount of its securities to banks and thrifts,
which used them to bolster their balance sheets. Some used TARP funds for
such purchases. The amount of Ginnie Mae purchases by banks and thrifts
increased from $41 billion in September 2008 to $113 billion one year later.
These purchases supported the FHA mortgage insurance program that was
backing much of the mortgage business in the wake of the subprime crisis.
The FDIC prepared to seize the failing Guaranty Financial Group on August
20, 2009, and it did so a few days later, in the tenth-largest bank failure ever
in the United States. The agency arranged its sale to a Spanish bank, Banco
Bilbao Vizcaya Argentaria. The FDIC added 111 banks to its problem list,
raising the number of troubled banks on that list to 416. The FDIC insurance
fund was at its lowest level since 1993, falling to $10.3 billion in August 2009
from $45.2 billion a year earlier. The FDIC became a large landlord for assets
from failed banks whose value totaled $1.8 billion but were difficult to sell

because of various flaws in the properties. The agency announced on August

27, 2009, that banks had an overall loss of $3.7 billion in the second quarter
of 2007 over the prior year.
Vulture investors thrived. SecondMarket bought frozen auction rate secu-
rities at discounts ranging from 10 to 13 percent and dealt in other illiquid
securities. Cogent Partners brokered interests in private equity funds that were
frozen, and Hedgebay Trading did the same for hedge funds that had suspended
redemptions. In contrast, college endowment funds suffered. Harvard’s endow-
ment had declined 30 percent in August 2009, despite the market rally, and Yale
faced a 25 percent contraction. Collectively, the two endowment funds lost
$17.8 billion in the fiscal year ending June 30, 2009. Columbia University’s
endowment fared a bit better, but still fell in value by 21 percent.
Natural gas prices plunged to a seven-year low. Retail chains reported that
sales were still slow in August, while the housing market continued to improve.
Housing sales were up 7.2 percent in July over those in June, but one in eight
residential mortgages was in foreclosure or delinquent. Jobless claims also
increased. Nevertheless, Fed chairman Bernanke stated on August 21, 2009,
“Fears of a financial collapse have receded substantially.”24 That statement
inspired a stock market rally, with the Dow closing at 9505.96. However,
concerns were raised that the appearance of an economic recovery might be
overly optimistic. To assure that was not the case, the Obama administration
announced, on August 26, 2009, Bernanke’s reappointment as Fed chairman.
That announcement was accompanied by a report that housing prices had
increased in most major cities in June.
Share prices for Fannie Mae, Freddie Mac, and AIG rose in late August,
and short-sellers abandoned the stock market as it continued to climb. Some
more good news emerged. World trade was reported to have increased in June
by 2.5 percent. Orders for appliances were up, as were new home sales, and
job losses were slowing, falling to 146,000 in August. The thrift industry was
reported to have had an overall profit for the second quarter, the first in two
years. The Commerce Department reported that consumer spending increased
in July for the third straight month. However, as August ended the Fed warned
that, while the economy was improving, it was still vulnerable to shocks.
Several states closed their government operations for limited periods in order
to save money. A judge prohibited the Rhode Island governor from shutting
down the government there temporarily, so he began laying off employees.
Unemployment hit 9.7 percent as September began, a twenty-six-year high,
but the rate of job losses continued to decline.
The Financial Times reported that, by the end of August 2009, the federal
government had earned a $14 billion profit on its various subprime crisis loan
programs.25 The New York Times reported on the same day that the government
made another $4 billion on TARP loan payouts.26 Still another report indicated
that the FDIC had received $9 billion in fees from its loan guarantee program.
In the meantime, the Fed’s balance sheet grew from $800 billion in 2007 to $2

trillion in 2009, as a result of assets acquired under its bailout programs. The
government was involved in making 90 percent of residential mortgages.
The FHA reported that its cash reserves were below 2 percent, and default
rates rose, with delinquencies exceeding 14 percent, more than twice the rate
for prime loans. The housing agency announced its intention to tighten its credit
standards. The FDIC warned that it might have to borrow from the Treasury,
as its insurance fund continued to be depleted. It then reached agreement
with the large banks for a plan under which they would prepay $45 billion
in FDIC safety fund fees, thereby shoring up the fund, which went into the
red in October after nearly 100 banks had failed during the year at a cost of
$26.6 billion.
On September 10, 2009, Secretary Geithner announced that the government
would allow its money market guarantee program to expire at the end of the
month. The FDIC also planned to end its financial services firm debt guarantee
program or to limit its access to troubled institutions. Later in the month, the
Fed announced the extension but eventual phase-out of its program for purchas-
ing billions of dollars of mortgages from Fannie Mae and Freddie Mac. It also
considered the creation of a program to conduct repurchase agreements (repos)
with money market funds. The Fed would collateralize its reverse repos with
those funds, mortgage-backed securities, and Treasury obligations. This was
intended to be an inflation-fighting tool, after the economy recovered.
In the meanwhile, consumer confidence continued to grow, but the price
of gold closed at $1,004.90 per ounce on September 11, 2009, setting a new
record. The Dow closed at 9605.41 that day. Four days later, Fed chairman
Bernanke declared that the recession in the United States was probably over,
after a report of a sharp increase in retail sales. He cautioned, however, that
growth in the economy was likely to be only moderate through 2010 and that
job growth was also expected to be slow. Mervyn King, the governor of the
Bank of England, made a similar statement about the British economy the same
day but was more pessimistic on growth, expecting it to be even slower.
Barclays announced on September 16, 2009, the sale of $12.3 billion in
illiquid assets to a fund created by some of its former executives. The bank
lent most of the purchase price to that fund. KKR provided $700 million in
financing to the faltering Eastman Kodak. AMR obtained $2.9 billion in new
financing in September. During the week of September 14, 2009, more than
$40 billion in corporate bonds was sold. Housing prices were reported to
have increased in July, and housing starts experienced an overall increase in
August, but construction of single-family houses was down, as were sales of
previously owned homes. Household wealth was reported to have increased
by 3.9 percent in the second quarter of 2009. However, unemployment in
California hit 12.2 percent, a seventy-year high.
Bank of America paid $425 million to terminate a loss-sharing arrange-
ment with the government over Merrill Lynch assets, which was a part of
the Merrill Lynch rescue. The arrangement was never used, so it was a rather

steep price to pay to exit the program. The Government Accountability Of-
fice (GAO) reported the recovery of AIG at the end of September 2009 but
expressed doubt that the government would ever be repaid its bailout money.
John Mack announced his departure as CEO of Morgan Stanley and declined
any bonus for 2009 but planned to remain as chairman. He was succeeded
as CEO by James Gorman. Jamie Dimon also shook up top management at
JPMorgan Chase.
The CDO market was liquidating and unwinding large amounts of trans-
actions, as it became possible to sell the underlying collateral. An estimated
$350 billion in notional amount of CDOs was in default. The IMF predicted
that banks would face global write-offs of another $1.5 trillion by the end of
2010. The index of leading indicators increased in August 2009 for the fifth
month in a row. The Dow was up 50 percent on September 22, 2009, over its
low in March 2009.
On September 23, 2009, the Fed announced that it would keep its interest
rate target at 0.25 percent and expected the Fed funds rate to remain low for
an extended period. Two days later, it reported that it would cut back its Term
Auction Facility (TAF) by reducing funds available for eighty-four-day loans
from $50 billion per month to $25 billion. It planned to maintain the resources
for twenty-eight-day loans under this program at $75 billion through January
2010. In addition, it reduced its swap program for distressed debt from $75
billion monthly to $25 billion.
Meeting in Pittsburgh on September 24 and 25, the Group of Twenty dis-
cussed how to coordinate their economies. Among other things, this would
include increasing consumer demand in China, reducing worldwide reliance
on consumer demand from the United States, and increasing investment in
Europe. It was not clear how such coordination could be implemented, other
than through peer review by the member nations and technical support from
the IMF. The Group of Twenty also agreed to increase regulation of financial
institutions, complex financial instruments, and executive pay.
The UK government announced that its largest banks agreed to curb com-
pensation by prohibiting multiyear guaranteed bonuses and a deferral of bo-
nuses by prorating them over three years with clawback rights if the bonuses
proved to be unjustified. The European Union announced the results of its bank
stress tests on October 1, 2009, concluding that the twenty-two largest banks
were in sound condition and could withstand losses of up to $585 billion if
the economy faced difficulties again.
The IPO market in the U.S. boomed as September ended. The IPO of A123
Systems was a hot issue, rising more than 50 percent on its first day of trading.
Two large mergers were announced, one involving Xerox’s acquisition of Af-
filiated Computer Services for $5.6 billion, and the other, Abbot Laboratories’
acquisition of the pharmaceutical business of Solvay for $6.6 billion.
Toxic subprime securities had a rally in September and were expected to
boost third-quarter results. Banks repackaged some of their securitizations by

bundling bad mortgages in one offering and good mortgages in another. The
good-mortgage pools were then given high credit ratings by the rating agen-
cies, in a process called REMIC (real estate mortgage investment conduits)
that reduced bank capital requirements.
The Dow had its best third quarter in 2009 in seventy years. The job mar-
ket was still suffering, and there were six people for every one job opening.
Although the rate of job losses slowed in September, unemployment reached
9.8 percent for the month. Manufacturing activity increased, but car sales
dropped sharply in September after the cash-for-clunkers program ended. The
Fed also expressed concern over distressed commercial real estate loans, for
which the banks were slow in recognizing losses and reserving against those
losses. Corporate profits were up 10.8 percent for the third quarter.
Fourth Quarter
Australia raised its interest rates on October 6, 2009, providing another indi-
cation that recovery was under way around the globe. Norway raised its rates
later in the month. Société Générale announced the same day that it would
repay the bailout funds that it received from the French government, to be
made from a $7 billion rights offering. Lloyds Banking Group encountered
resistance from the UK government in trying to exit a government insurance
plan on the value of its assets by raising private capital. European regulators
forced large financial institutions bailed out during the subprime crisis to
sell noncore operations. The European Union required such divestments as a
condition of a state-sponsored bailout. For example, Royal Bank of Scotland
was required to sell its profitable insurance operations, a commodity trading
unit, and a payment services firm. The British government split Northern Rock,
the bank that was nationalized during the subprime crisis, into a “good” bank
and “bad” bank, so that assets could be sold. The Dutch government ordered
ING to be broken up after a $14.9 billion bailout.
The price of gold set a new record on October 7, 2009, reaching $1,050
per ounce. Traders predicted that it could go as high as $1,500 per ounce. The
Dow Jones Industrial Average hit a yearly high on October 9, 2009, closing at
9864.94. Retail vacancies were up, and consumer credit was reported to have
fallen by $12 billion in August, but retail sales rose in September for the first
time in more than a year. Existing house sales were reported to have increased
by 9.4 percent in September.
The government’s $75 billion loan modification program was stalled.
Some 500,000 mortgages had been modified as October began. However, the
Congressional Oversight Panel reported that the program would delay only
about half the predicted mortgage failures and that many of the mortgages be-
ing modified could be expected to default as well. These modifications were
made as stated income loans that required no documentation of the borrower’s
income for three months, during which the borrower was required to make

timely payments of the modified monthly mortgage payment, which in most

cases did not occur. A front-page article in the New York Times claimed that this
Making Home Affordable program was actually hurting many of the people
it was seeking to help by encouraging them to continue to make mortgage
payments on homes they could not afford and that they would eventually lose
after their last savings were exhausted.
The Obama administration announced in December that it would require
lenders to submit plans to the Treasury Department showing how they would
increase the number of mortgage modifications. The Treasury threatened to
fine lenders who did not make sufficient numbers of modifications. That threat
had little effect. In an article that appeared in the New York Times over the
Thanksgiving weekend, Assistant Treasury Secretary Michael S. Barr criticized
banks for continuing to drag their feet.
Wells Fargo placed a giant bet in its mortgage modification program, al-
lowing interest-only payments on subprime pick-a-pay mortgages for as much
as ten years in the hope that the housing market would recover and bring the
mortgages out from under water. Vulture investors bought subprime mortgages
at a steep discount, modifying their terms to make them more affordable under
a new FHA-guaranteed mortgage. This shifted the risk of default from the loan
originators to the FHA. The FHA reported that more than 24 percent of the
loans that it insured in 2006 and 2007 were delinquent or faced foreclosure.
Lawrence Summers, Obama’s economic adviser and a former treasury sec-
retary, stated on October 12, 2009, that the economy appeared to be returning
to normal but that “major slack” remained in the system due to weak demand.
Business was further heartened after the Obama administration reversed its
plan to raise $200 billion from taxes on the foreign earnings of U.S. firms.
The administration’s efforts to curb executive pay faltered. The larger financial
firms planned to pay a record $140 billion in bonuses for 2009, a 20 percent
increase over 2008. Goldman Sachs had another big profit of $3.19 billion in
the third quarter, raising the potential for record bonuses. The firm made at
least $100 million on more than half the trading days in the third quarter.
Goldman tried to soft-pedal its bonus plans in order to dampen the public
outcry. Goldman’s CEO, Lloyd Blankfein, publicly apologized for saying that
Goldman was “doing God’s work” and admitted that it had made mistakes in
the run-up to the subprime crisis. On November 17, 2009, he announced the
creation of a $500 million fund to help small businesses hurt by the crisis.
A front-page article in the New York Times derisively noted that this totaled
only about 3 percent of the amount that Goldman had reserved for year-end
employee bonuses. The Wall Street Journal pointed out that this was one
way for Goldman to meet the Community Reinvestment Act requirements to
which it was subject after converting to bank holding company status during
the crisis.
An inspector general’s report challenged Goldman’s claim that AIG’s
failure would not have endangered the firm, noting that the government had

fully covered Goldman’s $22.1 billion exposure to AIG. A New York Times
article claimed that Goldman had put much of AIG’s exposure to subprime
derivatives on AIG’s books. Another report criticized the Federal Reserve
Bank of New York (New York Fed) for failing to negotiate a better deal with
the investment banks holding positions with AIG. Neil Barofsky, the special
inspector general in charge of overseeing TARP, issued a report in November
2009 that criticized the New York Fed for paying off Goldman and other
investment banks in full when AIG was rescued. At the time of that bailout,
the chairman of the New York Fed was Timothy Geithner, whose resignation
from his current post as treasury secretary was now called for by a group of
Republican senators. These criticisms were followed by a demand from some
of Goldman’s largest shareholders that some of the money in the bonus pool
be used for dividends. In December 2009, the firm announced that its thirty
top executives would not receive bonuses, but, instead, would receive stock
that could not be sold for five years.
The market looked strong enough for the Blackstone Group to announce
a plan to sell some of its portfolio companies through IPOs or private place-
ments. Blackstone and Fortress Investment Group both had profitable quarters,
positioning them to start earning performance fees once again. The private
equity group Apollo Global Management announced renewed plans for a
NYSE listing.
JPMorgan weighed in on October 14, 2009, with a third-quarter profit of
$3.59 billion. The Dow passed 10000 that day. IBM announced a 14 percent
increase in profits for the third quarter. General Electric reported profits of $2.5
billion for the quarter. Citigroup had profits of $101 million for the quarter on
revenues of $20.4 billion, its third straight quarterly profit. Bank of America
had a larger than expected third-quarter loss of $1 billion. Charles Schwab
experienced a 34 percent decline in profits in the third quarter. Morgan Stanley
posted a $757 million profit, its first quarterly profit in a year.
Deutsche Bank reported profits of $2.1 billion, but much of that was at-
tributable to tax benefits. Credit Suisse reported a $2.33 billion profit for the
quarter. However, UBS posted a loss for the quarter, after sizable assets were
withdrawn from the bank as fears mounted over government prosecutions of
tax evaders using that bank’s tax shelter programs. Lloyds Banking Group
announced a further 1,000 job cuts, bringing its total cuts during the subprime
crisis to 9,000. Barclays took write-offs totaling over $10 billion in the first
three quarters of 2009 and expected at least another $5 billion in the fourth
quarter. However, the bank did have a profitable third quarter.
Freddie Mac lost $5 billion in the third quarter. Fannie Mae had a third-
quarter loss of $19.8 billion and requested $15 billion more in government
bailout funds. This brought the total bailout for Fannie Mae and Freddie Mac
to $111 billion. Those two entities faced further large losses in commercial
apartment buildings.
AIG reported a reversal of collateral flows on its credit-default swaps,

bringing billions back into the firm. It posted its second quarterly profit in
a row. Robert Benmosche, the firm’s new CEO, chafed under government
pay restraints and threatened to resign, as did five other AIG executives. Ten
executives who reported directly to Benmosche had lost a total of $168 mil-
lion after AIG’s stock tumbled, and they were anxious to recover those losses.
Barofsky relented and allowed one AIG executive to receive a $4.3 million
bonus so that he would not resign.
AIG general counsel Anastasia Kelly, who had led the executive pay revolt
against Barofsky, resigned and demanded millions of dollars in compensation
pay to which she was entitled under her employment contract if her pay was
cut substantially. Kelly was subjected to an investigation by an outside law
firm, but apparently they could find no wrongdoing. Kelly, who had formerly
served as Fannie Mae’s general counsel during its subprime buildup, was paid
$3.9 million in severance by AIG and was replaced by Thomas Russo, who
had been the general counsel at Lehman Brothers at the time of its demise.
The remaining executives receiving the controversial bonus payments agreed
to return $40 million of the $168 million they had received. Barofsky was
demanding a return of an additional $5 million, and AIG was trying to claw
back that and more by withholding $21 million in bonuses due to workers
who had left the firm. This continuing controversy led to another resignation
by still another senior executive, John Plueger, the recently appointed head
of AIG’s aircraft leasing unit.
AIG settled class-action litigation brought by the public pension funds of
Ohio, California, and other states for $725 million. Although this settlement
was to be funded largely by a new capital raise, the effect was that the American
taxpayers who bailed out AIG would bear this cost, directly or indirectly.
The number of companies that exceeded earnings expectations set a new
record in the third quarter of 2009, but a lot of those earnings were attribut-
able to one-time cost-cutting measures, and revenues actually declined by 10
percent from the year before. Corporate bankruptcies slowed overall. However,
Capmark, a major lender to commercial developers, declared bankruptcy as
October ended. Housing prices had increased for three straight months, but
concern rose that the market could weaken again as home price increases
slowed in September. Housing sales were down by 10.6 percent in October from
the prior year, and construction was flat, but pending sales were up as a result
of the tax credit for new home purchases. Consumer confidence fell sharply
in October 2009, but incomes and durable goods orders as well as business
spending increased. Manufacturing worldwide increased in September but
slowed in October. The stock market was in a slump at the end of October, as
the Dow fell to 9762.69 on October 28, 2009. It rallied on October 29, after
the release of a report that GDP grew in the third quarter, an increase driven
largely by government spending, but the next day that average fell by almost
250 points. The price of gold reached $1,084.30 per ounce on November 4,
2009, and $1,138.60 on November 17. And in the beginning of November,

Warren Buffett announced the purchase of Burlington Northern Santa Fe for

$26.3 billion.
Issuers sold some $6 billion in corporate bonds in the first week of Novem-
ber. Some $90 billion in bonds backed by consumer CDOs had been issued un-
der the TALF program since its inauguration in March 2009, but by November
of that year participants had lost interest. The Obama administration proposed
that the remaining TARP funds be used to reduce the federal deficit.
The Fed announced again that it intended to keep interest rates exceptionally
low for an extended period, which meant at least six months. That statement
was followed by a report that the unemployment rate had reached 10.2 percent
in October, a twenty-six-year high. The stock market, nevertheless, rallied
on November 9, 2009, with the Dow closing at 10226.94, its highest level in
thirteen months. This did not satisfy some members of Congress, who, led by
Representative Ron Paul (R-TX), inserted a provision in the regulatory reform
legislation pending in the House Financial Services Committee that would
require GAO audits of the Fed. A limited form of that provision and legislation
broadly reforming financial services regulation passed the House on December
11, 2009, but passage was delayed in the Senate until July 2010.
GDP had declined in the prior four quarters, but in the third quarter GDP
growth was reported to be a low but positive 2.2 percent. The Obama admin-
istration claimed on October 30, 2009, that the stimulus package had created
640,000 jobs, but the economy lost 175,000 jobs in October alone. The Wall
Street Journal claimed that the Obama administration had overstated by
20,000 the number of jobs created by the stimulus. President Obama asserted
on November 18, 2009, that the U.S. economy could face a double-dip reces-
sion if government borrowing was not curbed. At the same time, however, he
promoted health-care legislation under consideration in Congress that would
cost nearly $1 trillion over the next decade. President Obama also signed an
Executive Order on November 17, 2009, creating a new Financial Fraud En-
forcement Task Force to replace the Corporate Fraud Task Force established
by the Bush administration in 2002, which had a decided lack of success in
its criminal trials and appeals. The creation of this new entity by President
Obama followed the high-profile loss of a criminal case brought against two
Bear Stearns hedge fund managers after the funds that they managed failed
and touched off the subprime crisis.
The Treasury was able to sell $44 billion in two-year notes on November
23, 2009, at a record low yield of 0.802 percent. Lloyds raised $14 billion on
the same day through a rights offering, but sold the rights at a sharp discount.
Loan balances fell by 3 percent in the third quarter. Mortgage delinquencies
rose to one in seven residential mortgages that month, up from one in ten a
year earlier. The number of homes underwater nationwide reached 23 percent
in November. In Florida the proportion was 45 percent, while in Nevada it
was 64 percent.
The number of bank failures in 2009 reached 125 in November, at which

point the FDIC insurance fund had an $8.2 billion deficit. The number of
problem banks rose from 416 to 552 in the third quarter. For the same pe-
riod, state and city tax revenues declined by 7 percent, and further declines
were predicted. California badly needed federal relief to cover a $21 billion
shortfall in the state budget. Claims for unemployment benefits fell during
Thanksgiving week.
Financial markets were disrupted by the announcement on November 26,
2009, that Dubai World, the Dubai government’s investment arm, sought a
moratorium on its $59 billion in debt. Japan startled the world on December
1, 2009, by announcing an injection of $115 billion into its economy, which
was facing another round of deflation.
In-store sales in the United States over Thanksgiving weekend were slightly
higher than the year before, but online shopping increased 11 percent over
the same period. The Fed’s Beige Book also showed modest improvements in
the economy. The price of gold set still another record on December 2, 2009,
closing a $1,212 an ounce. Two days later, it fell by $48.60, after a report was
released showing that unemployment had fallen to 10 percent and that only
11,000 jobs were lost in November. It was also reported that consumer debt
had fallen again in October. The news in the housing market for November,
however, was not good. New home sales declined by 11.3 percent.
Bernanke faced tough questioning at confirmation hearings for his second
term as Fed chairman. He admitted that mistakes had been made all around,
testifying that the Fed should have required banks to hold more capital and
should have required better risk management controls. He also asserted that
regulatory defects had allowed the banks to falter due to subprime lending,
not a housing bubble touched off by low interest rates. President Obama an-
nounced a plan for $50 billion more in stimulus on December 9, 2009. At the
same time, however, the government made it difficult for Citigroup to pay back
the first $20 billion in TARP funds received by the bank. Citigroup’s stock
had recovered to the point that Kuwait’s sovereign wealth fund was able to
sell its $4.1 billion investment in Citigroup at a profit of $1.1 billion, a return
on its investment of 36 percent.
The Dow closed at 10471.50 on December 11, 2009. President Obama was
displeased that bankers opposed his financial reform legislation. He called a
group of them to the White House on December 15, 2009, to persuade them to
increase lending. In December the government sold TARP warrants received
from JPMorgan Chase for $936.1 million and those from Capital One Financial
for $146.5 million, bringing the government’s total sales of those instruments
to over $3 billion. However, it had to postpone a sale of its Citigroup equity
after that financial group had difficulty selling $17 billion in stock on December
16, 2009. Citigroup claimed that the low price on that offering was due to a
competing effort by Wells Fargo to raise capital. However, both Wells Fargo
and Citigroup repaid a total of $45 billion in TARP funds, leaving $25 billion
for Citigroup to repay. Citigroup also terminated the arrangement under which

the federal government had agreed to share losses in a pool of what during the
height of the subprime crisis had appeared to be $300 billion of potentially
bad Citigroup assets. Those and other repayments returned $161 billion of the
$245 billion used to rescue some 700 financial institutions under the TARP
program. General Motors also announced its plan to repay its $6.7 billion in
TARP loans in 2010, which it did, but the government still held a large equity
stake from its capital injection under TARP.
Fannie Mae and Freddie Mac had disbursed $112 billion of the $400 billion
in government funds committed to their rescue. The government disclosed
a suspension of purchases of Fannie Mae and Freddie Mac obligations and,
instead, a raising of the $400 billion ceiling on its commitment to those GSEs.
The government agreed to supply capital to them as needed, thereby creating
an unlimited guarantee of their operations. Freddie Mac and Fannie Mae were
also allowed to pay their CEOs $6 million each over the next two years.
Pending home sales declined in November, but U.S. factory orders rose in
that month. Christmas sales were up by 3.6 percent over the prior year, and au-
tomobile sales increased by 15 percent in December. Unemployment remained
at 10 percent and 85,000 jobs were lost in December. Apartment vacancies
were at a high of 30 percent in 2009 and rents were down by 3 percent.
The Treasury Department raised a record $2.1 trillion through sales of debt
instruments in 2009. The level of junk bond sales also set a record in 2009.
David Tepper, a hedge fund manager, made $7 billion on bets in Citigroup and
Bank of America shares in 2009, of which he retained $2.5 billion.
The stock market as a whole experienced the worst decade ever between
1999 and 2009, worse than even the 1930s. NYSE-listed stocks lost, on aver-
age, 0.5 percent each year since 1999. That loss was even greater if inflation
is factored in. Nevertheless, the stock market as a whole was up by almost
25 percent in 2009, after falling by 37 percent in 2008. The Dow rose 18.8
percent during 2009, an increase of 61 percent from its March 2009 low. The
NASDAQ was up 43.9 percent in 2009 over the prior year, and the S&P 500
was up 23.5 percent. The price of gold at the end of the year was $1,095.20
an ounce, after reaching a record high of $1,217.40 on December 3. The price
of crude oil closed for the year at $79.36 per barrel. Global manufacturing
increased in December, and U.S. manufacturing grew in that month at the
fastest rate in more than three years, but the number of bankruptcies in 2009
was almost one-third higher than in 2008.
Venture capitalists began to make more investments in start-up enterprises.
However, a survey of start-up companies indicated that less than 20 percent
planned to make an initial public offering because of the regulatory hazards
associated with that process.
Further uncertainty was raised when the Bank for International Settlements
invited central bank representatives from the major countries and leading fi-
nanciers to a meeting in Basel to discuss concerns that there was a resurgence
under way of excessive risk taking by large banks. Large brokerage firms still

handled almost half of the money under management for individual investors,
but some brokers fled those firms as compensation limits continued to be an
issue. However, adjustments in the delivery of financial services resulting
from the subprime crisis had only just begun, with their ultimate course still
anyone’s guess, especially with regulatory uncertainty hanging over the
market. That uncertainty continued even after the enactment of regulatory
reform legislation because of the complexities it involved.
JPMorgan reported a profit of $3.28 billion in the fourth quarter of 2009,
up from $702 million in fourth quarter of 2008. The bank tried to quell the
furor over bonuses by restricting them to half the total amount paid in 2008.
That effort failed. Critics pointed out that the bank was still paying out $9.3
billion in bonuses, an average of $378,000 per employee. The JPMorgan CEO
Jamie Dimon was given a payout of $17.6 million, mostly in stock. JPMorgan
was also requiring the bonus pool to share the cost of a 50 percent surcharge
imposed by the English government on bankers posted in London. Most of
JPMorgan’s profits were in trading and investment banking. Its retail bank-
ing operations posted a loss as a result of mortgage defaults and continuing
expenses associated with the acquisition of Washington Mutual Inc. This last
bit of news sent the stock market reeling.
Citigroup posted a fourth-quarter loss of $7.6 billion, resulting in a loss of
$1.6 billion for the year. The Citigroup CEO Vikram S. Pandit agreed to ac-
cept only $1 in salary until he returned Citigroup to profitability. Pandit later
announced that he planned to sell about 40 percent of the bank’s operations
and declared that no bank should be too big to fail.
Bank of America lost $5.2 billion for the quarter and $2.2 billion for the
year. It was reported in the press that the new Bank of America CEO, Brian
Moynihan, was spending about half of his time in Washington, DC, meeting
with regulators instead of focusing on bank business. The bank did announce
that it was planning to add some 2,000 new brokers in its Merrill Lynch op-
erations.
Bank of America and its former CEO Kenneth Lewis were sued by New York
Attorney General Andrew Cuomo for failing to disclose the large unexpected
losses at Merrill Lynch just before the shareholder vote on their merger. The
SEC brought similar charges against the bank but did not attack Lewis. Bank
of America settled with the SEC by paying $150 million, money that would
come out of shareholders’ pockets. Lewis took home an $83 million retirement
package. His successor, Brian Moynihan, was paid $6.5 million in 2009. A
Merrill Lynch executive, Thomas Montag, was paid $29.9 million in 2009.
Morgan Stanley had a small profit in the fourth quarter but posted a loss
for the year. Nevertheless, the company announced that its 2009 bonus pool
would be increased over the 2008 amount. The new Morgan Stanley CEO,
James Gorman, was paid $15 million for the year. Wells Fargo did better,
reporting fourth-quarter profits of $2.82 billion. The Wells Fargo CEO, John
G. Stumpf, was paid $18.4 million for his work in 2009.

Goldman Sachs had a staggering profit of $13.39 billion for the year and
$4.79 billion for the fourth quarter. The firm had made trading profits of over
$100 million on 131 separate trading days during 2009. Bowing to political
pressure and public opinion, the firm announced that it was limiting its bonus
pool to $16.19 billion, about $3 billion less than expected. Lloyd Blankfein,
the Goldman CEO, was given a bonus of $9 million, down from $68 million in
2007. There is, however, more than one way to skin a cat. Blankfein received
an additional $18.7 million in 2009 from his investments in Goldman Sachs
private equity funds. Another $80 million was paid out to other senior Gold-
man executives participating in those funds.
American Express reported net income of $52 million in 2009, and its CEO,
Kenneth Chenault, was paid $17.4 million for that work. UBS AG reported its
first quarterly profit in more than a year but was being hurt by an exodus of
wealthy clients concerned with disclosure of their accounts to tax authorities
in the United States and Europe. Nevertheless, UBS paid out some $95 mil-
lion in bonuses for 2009 to its most senior executives, which was ten times
the amount paid in 2008. The Government of Singapore Investment Corp., a
sovereign wealth fund, reported that the value of its UBS holdings had dropped
from $11 billion to $6 billion, a paper loss of some $5 billion.
Credit Suisse paid its CEO, Brady Dougan, $17.9 million for his work in
2009 after his bank made a profit of $6 billion. Barclays reported a $14.71
billion profit for 2009, driven largely by profits from its Lehman Brothers ac-
quisition. Deutsche Bank AG posted a profit of $5.4 billion in 2009. Its CEO,
Josef Ackermann, was paid $13 million for returning the bank to profitability.
Foreign companies were continuing to delist from U.S. exchanges because
of regulatory costs and liability exposures from shareholder lawsuits. Among
those leaving were Daimler AG, Deutsche Telecom AG, and AXA SA.
The federal government was experiencing large profits on the credit-default
swaps it had taken over when it bailed out AIG. This was due to a recovering
credit market and continued performance on the contracts it had insured with
those instruments. In addition, AIG agreed to sell one of its insurance units
to MetLife Inc. for $14 billion, of which amount, $9 billion would go to the
government as a part of AIG’s bailout obligations. AIG later decided not to
sell its derivatives portfolio because it was increasing in value. AIG, neverthe-
less, suffered an $8.9 billion loss in the fourth quarter. That news was offset
somewhat by the announcement that AIG was planning to sell certain of its
Asian life insurance operations to Prudential PLC for $35.5 billion, twice what
it had been offered for that unit during the peak of the subprime crisis. How-
ever, Prudential encountered difficulty in raising the money needed to close
the transaction, and the deal fell through after AIG refused to reduce the price
by $5 billion. Prudential was required to pay $500 million to avoid closing
the sale. Another sale of other AIG operations was made to MetLife for $15
billion. AIG assured Congress in May 2010 that it would repay its obligations
to the government from the bailout. The AIG CEO, Robert Benmosche, was

proving to be a prickly presence for government regulators. The AIG board

chairman resigned in July 2010 after a dispute with Benmosche.
Fannie Mae reported a $15.2 billion fourth-quarter loss and a $72 billion
loss for the entire year. Ford Motor Co. posted a surprising profit of $2.7 bil-
lion for the year. Ford CEO Alan Mulally’s compensation for 2009 was set at
$17.9 million, but increases in the value of his stock options added another $50
million to his compensation package. Ford sold its Volvo operations to Geely
Holding Group, a Chinese company, for $1.4 billion, setting the stage for more
competition in the auto market. The economy in the United States grew by
5.7 percent in the fourth quarter of 2009. This was the highest growth rate in
six years. Inventories were dropping, which was a favorable sign that output
would expand to refill inventories. Sales of existing homes were reported to
have fallen by 16.7 percent in December, but the rate of mortgage delinquen-
cies slowed in the fourth quarter. Bank lending declined at a rate last seen
in 1942. U.S. household debt dropped by 1.7 percent in 2009, the first such
decline since records began to be kept for that statistic in 1945.
GDP increased by 5.6 percent in the fourth quarter and corporate profits rose
by 8 percent during that period. However corporate profits for the full year
were down 3.8 percent from those in 2008. Direct compensation for CEOs at
public companies fell by 0.9 percent in 2009 to a still healthy $6.95 million.
The highest paid executive was Lawrence J. Ellison. He received $85 million
for his work in 2009. The real money was made at the hedge funds. The top
twenty-five hedge fund managers averaged $1 billion each in compensation
in 2009. The highest paid member of that group was David Tepper with $4
billion. New York Stock Exchange member firms reported record profits in
2009 of $61.4 billion.
A New Decade Begins
President Obama went on an attack against Wall Street in January 2010. He

first flew to Boston in support of a Senate race for the seat left open by Ted
Kennedy’s death, where he bashed the banks. That effort failed, giving the
Republicans what they mistakenly thought were enough votes to block the
administration’s health care bill. That angered the president and he announced
two days later that the large banks would be limited in size and barred from
trading for their own accounts. He had also previously announced plans for
a tax on the large banks that would pay for TARP. This populist attack on the
banks was, according to the New York Times, being fueled by unions that were
being hurt by state government and industrial layoffs.
The president’s attack on the banks followed a troubling report of job claims
increasing to 482,000 in mid-January 2010. It also caused the Dow Jones
Industrial Average to drop by 213.27 points. The Obama administration was
by this time being criticized for not restoring jobs through its earlier massive
stimulus package and for running up staggering deficits.

In another blow to the administration delivered on the same day as the

announcement of the Obama bank proposal, the Supreme Court held that
campaign spending limits on corporations and unions were unconstitutional,
freeing the business community to unleash a counterattack. That did not deter
the president. He left the next day for Ohio where he made a campaign-like
speech that once again attacked the banks for their acceptance of bailout
funds that he demanded be returned in full. That speech, and concerns that
Ben Bernanke might not be approved in the Senate for a second term, sent
the Dow plunging another 216.90 points. Bernanke was later approved, and
he announced a plan to pay banks interest on their excess reserves held at the
Fed. It was hoped that this would induce the banks not to reduce reserves as
the economy improved.
Unemployment dropped in January to 9.7 percent, down from 10 percent
in December. However, 20,000 jobs were eliminated in January, and revised
figures for 2009 showed that job losses had been much higher than predicted,
1.4 million greater. New single-family-home sales dropped by 11.2 percent in
January, but prices were up. BlackRock Realty and Tishman Speyer Proper-
ties put the giant Stuyvesant Town and Peter Cooper Village in bankruptcy
on January 25, 2009. They had paid $5.2 billion for the property three years
earlier. It was now worth less than $2 billion. CalPERS was also an inves-
tor in the projects, and it lost $500 million as a result. Despite that setback,
BlackRock had a large increase in fourth-quarter income.
Consumer borrowing increased in January 2010 for the first time in almost
one year. The president released his budget request on February 1, 2010. He
was seeking $3.8 trillion in funding, which would result in a record deficit of
$1.6 trillion. The budget proposal would raise taxes on those families making
over $250,000 by allowing the Bush tax cuts to expire.
Continuing economic concerns spurred a market sell-off that occurred on
February 4, 2009, pushing the Dow Jones Industrial Average under 10000
before it rose to 10058.64 on February 9, 2009. European markets also fell
over concerns with Greek government debt. Speculators using credit-default
swaps were blamed for worsening the situation. It was claimed that Goldman
Sachs and others arranged swaps that concealed Greece’s true financial condi-
tion (and debt) when it was seeking approval from the European Union to use
the euro as its currency.
Greece was offered a $40 billion support package from the European Union,
but it turned out that the Greek debt problem was even worse than expected.
Greece then sought to increase the bailout to $60 billion, seeking funds from
the European Union and the IMF. That amount proved to be inadequate and a
$146.5 billion rescue package was agreed upon at the end of April. However,
deadly violence broke out in Greece after the government acted to impose the
harsh austerity measures demanded as a condition for the loan. The economic
woes of Greece spread to Spain and Hungary. In Italy, a judge authorized
criminal proceedings against eleven bankers working at JPMorgan, UBS, and

Deutsche Bank for their role in arranging credit-default swaps on a financing

arrangement for the city of Milan that caused losses totaling $2.3 billion. It
was also reported that economic growth in Europe had nearly stopped in the
fourth quarter of 2009.
Gold was dropping by some 14 percent in the first six weeks of 2010. The
Dow Jones Industrial Average rallied and reached 10268.81 on February 16,
2010, but consumer confidence was declining. Millions of homeowners were
unable or unwilling to refinance their homes to take advantage of lower interest
rates. Some 4.3 million homes were subject to foreclosure in February 2010,
up from 3.4 million in 2009.
Many banks were choosing short sales over loan modifications because
loan modifications were generally unwieldy and ineffective in preventing
subsequent defaults. The number of modified mortgages that subsequently
defaulted doubled in March 2010. The Obama administration was pushing
banks to make short sales without recourse to the homeowners for any deficit
in hopes this would spur a cleanup of delinquent mortgages. The adminis-
tration later announced a new mortgage modification program that required
mortgage lenders to allow three to six months of reduced mortgage payments
for qualifying homeowners receiving unemployment benefits. In response to
pressure from Massachusetts regulators, Bank of America announced that it
would be reducing mortgage principal for some borrowers by as much as 30
percent.
The Fed unsettled the market on February 19, 2010, after it raised its dis-
count rate from 0.5 percent to 0.75 percent. The Treasury Department also
announced that it was borrowing $200 billion that it would keep at the Fed for
use in its credit operations. TALF ended its program in March 2010. Despite
its shaky start, the program had financed some $100 billion in bonds that were
backed by consumer debt, including credit cards, student, and auto loans. The
program was credited with helping restore this credit market, and was expected
to return a profit to the government.
The FDIC reversed an earlier position and was challenging a $1.4 billion
tax break claimed by JPMorgan Chase under the stimulus bill passed by the
Obama administration in 2009 in connection with its acquisition of Washing-
ton Mutual. The stimulus bill prohibited banks, like JPMorgan, that received
TARP funds from claiming such tax breaks, but Washington Mutual had not
taken such funds before its failure. The FDIC was also considering restricting
so-called “Christmas capital” claimed by banks as revenue from assets bought
at a discount when taking over a failed bank.
Housing starts were down 5.9 percent in February due to a number of
winter storms. New homes sales in February were the lowest on record and
13 percent lower than in February 2009. However, pending home sales rose
by 8.2 percent in February, being spurred by foreclosures and the expiration
of a new home tax credit of up to $8,000. The unemployment rate remained
steady at 9.7 percent in February and job losses were lower than expected at

36,000. Retail sales also grew during the month. Credit markets were freeing
up, allowing corporations to raise almost $200 billion in the first two months of
2010, up almost $40 billion for the same period in 2009. The picture continued
to brighten with the Dow closing at 10907.42 on March 30, 2010. The Dow
was then up over 67 percent over its March 2009 low and it was the highest
close since May 2008.
The dollar was strengthening against the euro, reaching $1.33 on March
24, 2010. Crude oil closed at $82.17 per barrel on March 29, 2010. The junk
bond market was recovering with $31.5 billion in offerings in March 2010, the
highest amount ever for a single month. The number of mortgage delinquen-
cies fell in the first quarter of 2010, the first such decrease since 2006. The
number of subprime delinquencies dropped slightly in March, the first monthly
decline in four years. Such delinquencies fell from 46.9 percent of subprime
mortgages to 46.3 percent. That was up from 6.2 percent in 2006.
After much heated debate, the Obama administration’s universal healthcare
legislation was passed. It was projected to cost $940 billion over the next ten
years. The Congressional Budget Office announced a few days after the sign-
ing of that legislation that Social Security would be paying out more than it
was taking in during 2010, six years ahead of previous predictions. Several
companies announced massive loss charges to cover their expected increased
health insurance costs under the Obamacare program. AT&T Inc. announced
a $1 billion charge for those expenses; John Deere, $150 million; and Cater-
pillar, $100 million.
The Obama administration put an end to the private student loan market in
2010 with the passage of legislation that required students and parents to bor-
row directly from the federal government at a rate of 7.9 percent for parents,
4.5 percent for needy students and 6.8 percent for other students. Sallie Mae
then laid off 2,500 employees and Citigroup took a $500 million loss on its
student loan business.
Jobless claims in the third week of March were the lowest since December
2008. Some 162,000 jobs were added in March, but about one-third of those
were government hiring for the upcoming census. The unemployment rate was
still high at 9.7 percent. Housing sales rose 27 percent in March, spurred by
the $8,000 tax credit for first time homebuyers. Still, personal bankruptcies
were up in March with filings at a rate of 6,900 per day.
Auto sales were up during March and retail sales increased by 1.6 percent
during the month. General Motors repaid $6.7 billion of its $50 billion TARP
bailout loan. That payment was ahead of schedule, and the company had a
first-quarter profit of $865 million, its first quarterly profit in three years.
Chrysler also reported a profitable quarter. Ford posted a $2.1 billion profit
for the quarter. The Dow went through 11000 on April 12, 2010, and then
went to 11123.11 on April 14. The S&P 500 passed through 1200 on April 12
after JPMorgan Chase reported a 55 percent increase in profits for the first
quarter of 2010.

Bank of America also had a good quarterly profit of $3.2 billion that was
largely driven by profits at Merrill Lynch. Citigroup weighed in with a quar-
terly profit of $4.4 billion. The government then announced that it would begin
selling its ownership interest in the bank that was taken as a part of the TARP
bailout. The SEC agreed to an additional $75 million from Citigroup through
the settlement of claims that Citigroup failed to disclose in a timely manner
its $40 billion in subprime exposures during the crisis. However, a federal
judge objected to the settlement.
Goldman Sachs Group Inc. reported a $3.46 billion profit for the quarter,
did not experience a single trading day with profits of less than $25 million,
and made more than $100 million on thirty-five trading days. Nevertheless, the
firm was staggering from a fraud action brought by the SEC concerning one
of its subprime deals that is described in Chapter 7. A Senate investigation of
the firm was also drawing headlines after a front-page article in the New York
Times reported that Goldman Sachs executives were bragging about making
some serious money from shorting subprime mortgages during the crisis. This
led to an announcement that the Justice Department would be conducting a
criminal probe of Goldman. That report resulted in a $21 billion decline in
Goldman’s stock price.
Some shareholders sought to curb Goldman’s management through proxy
resolutions. One proposal came from the Maryknoll Sisters of Ossining and
sought to require greater disclosure on Goldman’s trading activities. It received
only 33 percent of the vote. A proposal to split Blankfein’s roles as CEO and
board chairman was also defeated but he remained under attack by populist
critics.
Freddie Mac reported a first-quarter loss of $6.7 billion and was requesting
another $10.6 billion from the government. Fannie Mae weighed in with a
quarterly loss of $11.5 billion and asked for $8.4 billion more in government
funds. This would raise the total bailout to those two entities to $145 billion.
Fannie Mae and Freddie Mac owned over 163,000 homes at the end of March
that had been taken over in foreclosures. That was more homes than the num-
ber existing in some large cities. MBIA, the monoline CDO insurer, had tried
to spin off its losses from those instruments but posted a first quarter loss of
$1.48 billion. Another monoline insurer, Ambac, reached a deal that cancelled
$16 billion in coverage for CDOs.
Recovery is Slow and Uncertain
President Obama traveled to Wall Street on April 22, 2010, to once again chide
the bankers on their opposition to his financial reform legislation. He also
used the SEC’s fraud case against Goldman Sachs (Chapter 7) as a means to
demand more derivative regulation. Banker bashing became a popular pastime
after the filing of the SEC’s action. Among other things, the SEC launched a
broad-scale investigation of CDOs that was directed at several major financial

institutions, including Morgan Stanley, JPMorgan, Citigroup, Deutsche Bank,

and UBS, as well as Goldman Sachs. The Justice Department also began an
investigation of CDO practices at Morgan Stanley, and Andrew Cuomo, the
New York attorney general, began an investigation of eight major financial
institutions concerning their role in rating CDOs.
More corporate bashing broke out over the massive oil spill from an explo-
sion that destroyed a BP drilling platform in the Gulf of Mexico. The Obama
administration came under heavy criticism for responding inadequately to
that disaster. The president then began publicly bashing the BP CEO Tony
Hayward, stating that he would have fired Hayward if he worked in his ad-
ministration. Hayward was then hauled before a congressional committee and
given a pillorying that exceeded even the bombast in the Enron and subprime
compensation hearings. The president also promised on national television that
he was looking for some “ass to kick.” Hayward was removed from office by
the BP board shortly afterwards.
The president suspended all offshore drilling. After complaints were re-
ceived that this would idle thousands of workers, the president demanded that
BP pay their lost salaries, as well as the entire costs of the cleanup. Demands
were being made that BP suspend its quarterly dividend, and the president
ordered that BP create a multi-billion dollar fund to cover cleanup costs. BP
thereafter agreed to those requisites, cutting its dividend and creating a $20
billion cleanup fund. The British government protested these attacks on one
of its most important businesses. These attacks and the damage estimates from
the oil spill caused BP’s stock price to be cut in half, shedding over $82 billion
in value. Adding further to the company’s woes, a criminal investigation of the
circumstances surrounding the explosion and spill was announced.
President Obama also found himself in a slanging match with WellPoint
Inc. CEO Angela Braly. Obama accused WellPoint of cutting off coverage of
women with breast cancer during his weekly radio address on May 8, 2010.
Braly then sent the president a letter in which she stated that he was spreading
false information, and that her company had not singled out breast cancer pa-
tients for rescission of coverage. However, WellPoint was forced to reduce its
request for a 39 percent increase in premium costs in California to 14 percent,
which the company predicted would cause it to lose $100 million.
The unemployment rate rose to 9.9 percent in April even though the number
of jobs increased by 290,000 during the month. The increase in the unemploy-
ment rate was attributed to a return of workers who had given up seeking
employment until the economy strengthened. Inflation was at a forty-four
year low as April ended, rising at a rate of less than 1 percent. Sales of new
homes rose by 14.8 percent in April 2010, as the first-time home-buyer tax
credit continued to attract buyers.
The financial markets caused grave concern on May 6, 2010, when the
Dow Jones Industrial Average dropped by almost 1,000 points in just a few
minutes—the “flash crash.” The sell-off was variously attributed to trading

errors, uncertainty in Europe over economic conditions, a Procter & Gamble

sell order, a large trade on the Chicago Mercantile Exchange by Waddell &
Reed, a mutual fund, and a large options trade by a hedge fund advised by
Nassim Taleb of “Black Swan” fame, which may have triggered high-frequency
algorithmic sell orders. Even after several months of investigation, the SEC
remained uncertain as to what was the actual cause of the crash. Mary Scha-
piro, the SEC chair, summoned the leaders of the exchanges to Washington
and they agreed to adopt circuit breakers to interrupt trading when such a
sharp downturn begins. Schapiro blamed a lack of uniformity in exchange
rules as furthering the problem. She also demanded that the exchanges build
a multi-billion dollar repository for trading data so that future events could
be more easily traced. The exchanges announced that trades executed at a
price of more than 60 percent below the share prices at the time of the flash
crash would be cancelled. This resulted in howls of outrage from traders who
thought they had made the killing of a lifetime. Algorithmic traders were also
under attack for using their computers to analyze price data faster than more
conventional traders.
The financial crisis that began in Greece continued to spread. The European
Union announced a $1 trillion bailout for the affected countries on May 10,
2010. The IMF was to supply about one-half of that funding. The European
Union had been prodded into action by the Obama administration, which re-
opened a swap facility with the European Union Central Bank that had been
employed during the subprime crisis to assure liquidity in Europe. The crisis
was driving down the euro and pushing gold to a new record of $1,219.90
per ounce.
The euro hit a four-year low on May 19, 2010, falling to $1.21. Germany
imposed restrictions on naked short sales on that day as a renewed credit
crunch struck European borrowers. This unilateral and unexpected action
by Germany sent stock markets reeling and irritated other European Union
members. Germany also announced a $95 billion reduction in its government
budget, as economic conditions in that country continued to falter. Great
Britain announced that it too would be cutting public sector spending. France
followed with a $54.8 billion cut in spending. The ECB predicted that Euro-
pean Union banks would have to write off some $240 billion of their assets
over the next two years.
The Dow Jones Industrial dropped by 376 points on May 20, 2010, clos-
ing at 10068.01. However, there was some good news. Residential mortgage
rates were at a near fifty-year low in the United States. The yield on two-year
Treasury notes was the lowest in history on May 25, 2010. The Dow dropped
below 10000 on May 26, 2010, and finished the month with the worst decline
for the month of May since 1940. Home sales dropped in May after the expira-
tion of the first-time homeowner tax credit. New homes sales dropped to the
lowest level since record keeping for such statistics began in 1963. Auto sales
and manufacturing were up for the month, but retail spending was lagging.

June began with a disappointing jobs report in the United States, causing
a steep market sell-off. The Dow Jones Industrial Average dropped by over
12 percent between April 26, 2010, and June 11, 2010. It then rallied for a
few days before faltering again. The Fed announced on June 23, 2010, that
it expected the economic recovery in the United States to remain weak and
that interest rates would remain unchanged at near zero for an extended
period of time.
Lincoln National, the insurance company, announced on June 14, 2010,
that it would be raising over $1 billion to repay its TARP bailout. At the same
time, state insurance regulators disclosed that they were backing down from
a proposal that would have imposed steep capital charges for insurance com-
panies investing in mortgage-backed securities. Marsh & McLennan agreed in
June 2010 to pay $500 million to settle Enron-era charges that it mishandled
pension funds of the State of Alaska between 1992 and 2004.
The Group of Twenty meeting in Toronto on June 28, 2010, was marred by
violent protests. The leaders attending the event rejected President Obama’s
plea for them to continue stimulus spending. Instead, they agreed to cut their
deficits in half over the next three years and to reduce stimulus spending.
This reflected not only a concern over deficits but also a belief that economies
outside the United States were recovering. The Bank for International Settle-
ments also warned against the risks of growing deficits and of keeping interest
rates too low for too long. The European Central Bank created some turmoil
when it announced that it was not renewing a bank liquidity facility, thereby
requiring banks to repay over $500 billion in one-year funds.
The Dow Jones Industrial Average dropped by 268.22 points on June 29,
2010, over concerns with diminishing consumer confidence. The Dow dropped
under 10000, settling at 9870.30. That average was down 12.8 percent from
its high for the year at the end of June. It dropped again on July 2, 2010, after
a discouraging jobs report was released. That report disclosed that, while the
unemployment rate had fallen from 9.7 percent to a still unhealthy 9.5 percent,
that drop was due to the fact that the labor force had decreased by 652,000.
Only 83,000 new jobs were added in June and nonfarm payroll dropped by
125,000 after the temporary census workers were discharged. The market ral-
lied on July 6, 2010, pushing back through 10000 and then the stock market
had its best week in nearly a year.
Wall Street was hiring again. JPMorgan reported a second-quarter 2010
profit of $4.8 billion, up 76 percent from a year earlier. However, the bank
reported that losses from consumer loans remained at extremely high levels.
Bank of America had a second-quarter profit of $3.1 billion, a drop of 3 percent
from the year before. The bank also announced that it was projecting a loss of
$4.3 billion in revenue as the result of the new financial services legislation
and that it would take a $7 to $10 billion charge for costs associated with that
legislation.
AIG lost $2.7 billion in the second quarter, but the loss was lower than

expected. AIG announced that it was in talks with the government on repay-
ment of its bailout funds, and its aircraft leasing unit repaid $3.9 billion to the
government later in the year. AIG also disclosed plans to make a public bond
offering. Citigroup had a second-quarter profit of $2.7 billion, which was 37
percent lower than the prior year. General Electric had a second-quarter profit
of $3.1 billion, a 16 percent increase in profit over the year before. Goldman
Sachs experienced an 82 percent decline in earnings in the second quarter due
to a $550 million settlement with the SEC (described in the next chapter),
increased taxes and losses in the equity market.
UBS had second-quarter profits of $2 billion. It also announced that it was
hiring executives from Goldman Sachs and Bank of America in order to beef
up residential mortgage lending through its U.S. brokerage unit. Apparently
UBS was prepared to once again face the risks of such lending. Morgan Stanley
reported a profit of $1.96 billion, triple that of Goldman Sachs. Wells Fargo
was down 3.5 percent for the quarter. MF Global Holdings posted a quarterly
profit, after posting losses in the prior six quarters. That firm was headed by
Jon Corzine, the former New Jersey governor and head of Goldman Sachs. He
was brought in to turn MF Global around after he lost a Senate race.
Apple, Microsoft, and Intel reported high earnings in the second quarter.
Dell, the computer company, removed a cloud over its head with a $100 mil-
lion settlement with the SEC, and Michael Dell, the company’s founder, paid
$4 million to settle account manipulation charges for the period 2002 to 2006.
Mark Hurd, the CEO at Hewlett-Packard Co. (H-P), was forced to resign after
discovery that he had falsified expense reports for a contractor with whom he
had a relationship. Hurd received a $35 million severance package and joined
rival Oracle. H-P sued to stop that hire, but quickly settled.
AT&T, Caterpillar, John Deere, and 3M had strong quarters. The airlines
were also returning to profitability. Ford reported a profit of $2.6 billion in
the second quarter, a 13 percent increase over that of the prior year. Bill Ford,
the executive chairman at Ford, had forgone any compensation for the prior
five years, but was given $15 million in compensation after the company an-
nounced its second-quarter results. He also cashed in $28 million in options
stock after that announcement.
Auto sales continued to increase in July, and General Motors reported a
second-quarter profit of $1.3 billion. Its CEO, Edward Whiteacre Jr., stepped
down and was replaced by Daniel Akerson. He was the fourth person to serve
in that position over the last eighteen months. General Motors announced plans
for an initial public offering in August 2010 that was expected to raise some $15
billion. Some lessons are never learned. General Motors also announced that it
was paying $3.5 billion for AmeriCredit, a large subprime consumer lender.
First-quarter growth in the U.S. was revised upward to 3.7 percent, but
second-quarter growth was slower than expected, dropping to 2.4 percent,
later revised downward to a troubling 1.6 percent. The Fed was predicting
a moderate 3 percent growth rate in 2010 for the U.S. economy as the third

quarter began. The consumer savings rate was up in May and June reaching
8 percent and 6.4 percent respectively, an increase from the pre-crisis rate of
less than 2 percent, and an indication of continuing concerns by consumers
with the economy. The trade deficit was increasing, as was the federal budget
deficit. The eurozone economies were picking up after their stimulus pack-
age was rolled out in June. The results of European bank stress tests were
announced on July 23, 2010. Only seven failed to pass, raising criticism that
the tests were too lenient. The German economy was showing particularly
strong signs of growth, but was facing a rising budget deficit.
New single-family home sales in the United States jumped in June and
housing prices rose in May. However, the housing market was still uncertain.
Inventories were increasing and housing starts and sales were slowing as the
loss of the $8,000 first-time home-buyer tax credit reduced interest in the
market. Indeed, new homes sales dropped in July to a fifteen-year low, falling
by 27 percent over the prior month. Nevertheless, the fixed rate for thirty-year
mortgages fell to 4.49 percent in the first week of July, touching off a wave of
refinancings. Fannie Mae posted a quarterly loss of $1.2 billion, after paying
the government $1.9 billion in dividends for the use of its bailout funds. This
was Fannie Mae’s lowest loss in three years, but it asked for $1.5 billion more
in government bailout funds. Freddie Mac’s loss for the second quarter was
$4.7 billion, and it sought an additional $1.8 billion in bailout money.
The unemployment rate in the United States remained at 9.5 percent in
July, with job losses of 131,000. At that time, over 11 percent of consumer
debt, totaling $1.3 trillion, was delinquent. Some $30 billion in home equity
and consumer lines of credit has been written off in the first seven months of
2010. Some one in seven mortgages in amounts of more than $1 million were
also delinquent and one in twelve mortgages of less than $1 million in value
were in the same condition.
The Federal Reserve Board was funding most mortgages through its lend-
ing facilities, and had been doing so for over a year. The total for that funding
exceeded $1 trillion. The government mortgage modification programs were
still struggling in July. Over 600,000 trial modifications were cancelled after
homeowners failed to meet their reduced obligations. This was about half of all
the trial modifications made under the Home Affordable Modification Program
(HAMP). Only 420,000 trial modifications had been made permanent at this
point and the number of applications for modification under the program had
slowed to a trickle.
KKR withdrew plans for a $500 million stock offering on August 9, 2010,
after it reported a 92 percent drop in earnings for the second quarter over the
year prior. This was KKR’s first earnings report after its listing on the New
York Stock Exchange. Quant hedge funds, those using quantitative analysis
to guide their trading, had shrunk from about $1.2 trillion under management
when the subprime crisis began in 2007 to less than $470 billion in August
2010 as investors lost faith in their profit-making abilities. On the other hand,

global merger activity was growing in August, including a $7.7 billion purchase
of McAfee by Intel and a hostile takeover offer by BHP Billiton of $39 billion
for the Potash Corp. in Canada.
The Fed expressed concern on August 10, 2010, with the pace of the
economy recovery and announced it would be buying Treasury bonds in order
to boost liquidity. The Fed governors were split over whether to shrink its
balance sheet by selling of assets. Bernanke persuaded a majority to maintain
the assets, which if sold would reduce the money supply. This division was
accompanied by renewed concerns with a possible “double-dip” recession, and
the Dow dropped by 265.42 points on August 12, 2010, in response to those
concerns. A technical indicator developed by James Miekka, called the “Hin-
denburg Omen” (named after the famous dirigible explosion), was predicting
a market crash in the next few months. This uncertainty was driving investors
out of the stock market and into bonds, pushing yields down to very low levels.
The thirty-year Treasury bond was yielding 3.67 percent on August 20, 2010
and the five-year Treasury only a meager 1.47 percent. Investors withdrew
over $33 billion from equity-based mutual funds between January and July
2010. Foreign issuers were also making Yankee bond debt issues in the U.S.
in record numbers. Even junk bond offerings were at a record rate for the total
amount of issuance as investors retreated from equity. However, new layoffs
were planned for Wall Street as the stock market faltered.
At this point, the only thing clear was that the country had survived the sub-
prime crisis, but it faced uncertainty over the recovery that seemed to be faltering
in the third quarter of 2010. The upcoming mid-term elections were focusing on
the economic problems that the Obama administration had, so far, been unable
to fix. It appeared that the Obama stimulus package passed the year before was
another costly failure. Politicians who voted for TARP were facing especially
tough fights for reelection in November, a subject that was pushing health care
aside as the hot button political issue. Another troubling financial indicator
was emerging: the federal budget deficit for the fiscal year ending September
30, 2010, was a massive $1.65 trillion, an increase in excess of $1 trillion over
the past two years. This was the largest deficit in percentage terms since World
War II. The Republicans went on attack in the mid-term elections charging the
Democrats with reckless spending as the cause of the deficit increase.
A political fight was also brewing over whether the Bush tax cuts should
be renewed before their expiration in 2011. The Obama administration was
seeking renewal only for those taxpayers making under $250,000, while
Republicans, and some Democrats, were seeking renewal of all the cuts. The
Republicans claimed that it was the wealthy that created jobs and a tax in-
crease would discourage those entrepreneurs from growing their businesses.
The Democrats were continuing their populist campaign against the wealthy
and were claiming that the tax increase would cut the deficit. They found an
unexpected ally in Alan Greenspan, who was seeking to restore his tattered
reputation by supporting more regulation and higher taxes, things that he had
opposed while serving as chairman of the Fed. Meanwhile, it was reported in

the press that the wealthy were engaging in a number of tax planning moves
to cut their taxes in anticipation of the expected tax rise in 2011.
President Obama’s “Recovery Summer” campaign failed to jump-start the
stalled economy. Unemployment was at 9.6 percent as the third quarter ended.
The president was under fire for his failed stimulus package, and it appeared
that his party would lose control of the House and possibly the Senate. More
criticism of the administration followed reports that stimulus checks in amounts
of $250 were sent to 89,000 individuals who were either dead or in jail. It was
also reported that Los Angeles spent $111 million in stimulus funds to save
fifty-five jobs, at a cost of about $2 million per job. The Washington, D.C.
area, where the funds were least needed, received nearly 300 percent more
stimulus funds per capita than the rest of the country.
The National Bureau of Economic Research (NBER) announced in Septem-
ber 2010, rather belatedly, that the Great Recession had ended fifteen months
earlier, in June 2009. There was little jubilation, since some 330,000 jobs had
been lost after the recession ended. This was the longest economic downturn
since the Great Depression and caused a loss of 7.3 million jobs, as well as an
average decline of 21 percent in individual net worth. One in seven Americans
were living in poverty in 2010, and almost half of all Americans were living
in a home receiving government entitlements.
Federal regulators seized three large “wholesale” credit unions in Septem-
ber 2010. Those institutions provided financing and back-office services to
retail credit unions. The government extended a $30 billion guarantee for the
remaining wholesale credit unions and held credit union assets once valued
at $50 billion for liquidation. Some 280 banks had failed between September
2008 and September 2010 and some 10 percent of all banks were on the FDIC
watch list. However, many banks doubled their earnings in the third quarter
by reducing loan loss reserves.
The stock market faltered over the summer but gained during September
and passed through 11000 on October 8, 2010. Foreign currency trading was
at a record level, as the value of the dollar plunged to a record low. Gold rose
to an incredible $1,370 an ounce in October. Other commodity prices were
soaring, including cotton, which rose to a level that had not been seen since
the civil war.
Bank of America, JPMorgan Chase and GMAC Mortgage temporarily
suspended further housing foreclosures in October because of documentation
problems, apparently caused by the “robo-signing” of mortgage documents.
Fannie Mae and Freddie Mac were holding nearly 200,000 foreclosed homes,
double the amount of the prior year. The Fed was continuing its efforts to
inflate the economy by low interest rates and quantitative easing through as-
set purchases. In the meantime, GDP grew by only a disappointing 2 percent
annual rate in the third quarter.

15. Regulation, Reform, and the Subprime Crisis
What Caused the Subprime Crisis?
Little attention was being paid to the root causes of the subprime crisis in its
aftermath. Congress had created a Financial Crisis Inquiry Commission (FCIC)
when it enacted the Fraud Enforcement and Recovery Act in May 2009. That
commission was tasked with determining the cause of the subprime crisis.
Although FCIC was supposed to be bipartisan, its chairman was an extremist
corporate governance activist, Phil Angelides, a former treasurer of California.
Angelides was known for his support of the California Public Employees’
Retirement System (CalPERS) corporate governance campaigns. He was in
all events unhurried and disorganized. FCIC did not begin its investigation
until January 2010 and did not plan to file a report until the end of the year,
and its hearings were desultory and few and far between.
The FCIC made a few headlines by attacking Goldman Sachs’ lack of
cooperation with its investigation. Those charges were made in the wake of a
sensational lawsuit by the Securities and Exchange Commission (SEC) against
Goldman Sachs (described below), and looked like just more piling on for
publicity. The FCIC also issued a number of preliminary staff reports that vari-
ously stated that inflated ratings by the rating agencies “may have contributed”
to the crisis; that “shadow” banking activities conducted by non-traditional
financial institutions were vulnerable to financial stress because of high lever-
age, reliance on short-term credit and lack of a government guarantee for their
debt; that there is an ongoing debate over whether securitization increased
mortgage default rates and whether federal legislation led to increased sub-
prime lending. Another staff report reviewed the growth of subprime lending
at Fannie Mae and Freddie Mac.
FCIC’s slow pace apparently led the president and Congress to write it off
as a non-starter, and they pushed forward with regulatory reform legislation
without stopping to determine what flaws in the present system had allowed
the subprime crisis to arise unnoticed by regulators. The legislation that was
passed in July 2010 was over 2,300 pages in length and intruded into every
corner of finance, but offered no assurance that another financial crisis would
696

Regulation, Reform, and the Subprime Crisis 697
not occur in the future. Before describing that legislation, some consideration
needs to be given to the root causes of the crisis.
Subprime Affirmative Action
Former treasury secretary Henry Paulson blamed the crisis on “bad lend-
ing practices.”1 Fed chairman Bernanke contended the cause was foreign
investors with an overly large appetite for subprime securities, causing U.S.
banks to lower their credit standards in order to meet that demand.2 Ber-
nanke and President Obama blamed AIG’s failure on irresponsible bets on
credit-default swaps. The new treasury secretary, Timothy Geithner, blamed
compensation practices that inspired excessive risk taking at financial ser-
vices firms. Actually, government housing policy can be more fairly blamed
for laying the groundwork for the subprime crisis. That policy sought to aid
the poor, especially racial minorities that historically have been the subject
of discrimination, by providing financing that would allow them to live in
their own homes. Although well intended, that policy was badly flawed
in its implementation. The federal government forced the banks and the
government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac
to make subprime loans in massive quantities. That effort began with the
passage of the Home Mortgage Disclosure Act (HMDA) of 1975,3 which
required banks to disclose the source of their mortgage loans. This was an
attack on the practice called “redlining,” whereby banks refused to lend into
areas with higher default rates. The “redlined” neighborhoods were often
where minorities were concentrated. That legislation was followed by the
Community Reinvestment Act (CRA) of 1977, which required banks to meet
the credit needs of minorities.
Under CRA, banking regulators scored banks on the amount of their loans
to poorer neighborhoods. CRA scores were required to be considered by bank-
ing regulators before approving bank mergers. The CRA had little immediate
effect until the Riegle-Neal Interstate Banking and Branching Efficiency Act
of 1994 removed restrictions on interstate mergers. The removal of those
and other barriers to expansion set off a boom in bank mergers. The Clinton
administration took advantage of the demand for bank mergers through its
National Homeownership Strategy, which sought to increase lending to sub-
prime borrowers through the pressure of the CRA. To demonstrate that the
administration meant business, as one author asserts:
Banks were compelled to jump into line, and soon they were making thousands
of loans without any cash-down deposits whatsoever, an unprecedented situa-
tion. Mortgage officers inside the banks were forced to bend or break their own
rules in order to achieve a good Community Reinvestment Act rating, which
would please the administration by demonstrating generosity to underprivileged
borrowers even if they might default. Easy mortgages were the invention of Bill
Clinton’s Democrats.4

The Federal Reserve (the Fed) also adopted new CRA requirements that, “in
the words of the Federal Reserve Governor who wrote the regulations, set up
soft quotas on lending in underserved areas.”5
In order to please regulators, banks made pledges of hundreds of billions of
dollars in CRA loans. Bank of America announced a ten-year CRA subprime
lending pledge of $750 billion in 2003. JPMorgan Chase made a larger $800
billion CRA pledge. Citibank made a ten-year $115 billion CRA pledge in 1999.
Washington Mutual made a CRA pledge of $120 billion in 1998. Between
1992 and 2007, CRA pledges totaled over $4.5 trillion.
The Clinton administration’s CRA efforts led to an 80 percent increase in
the number of subprime mortgages. In 1995, banks were allowed to move their
CRA loans off their balance sheets through securitizations. Bear Stearns made
its first such offering in 1997, a $385 million offering. The firm underwrote an
additional $1.9 billion in CRA securitizations over the next ten months. Ten
years after that offering, such securitized loans would destroy that venerable
firm and push Wall Street to the subprime abyss. The government also made it
easy for the banks to obtain loans to meet these commitments by giving CRA
credit for purchases of subprime mortgages originated by nonbank subprime
lenders. This led to “warehouse” operations, in which mortgages were pur-
chased from nonbank originators and then resold through securitizations.
CRA “Extortion”
Community activist groups used the CRA to demand funding for their organiza-
tions from banks as a condition of not protesting mergers on CRA grounds. The
“CRA put a wad of power in the hands of community organizations to damage
banks that they felt weren’t doing enough for poor people. These community
organizations became the dispensers of money for zero-down mortgages for
poor people, again a lovely thing, but it didn’t turn out so well.”6 Many large
banks gave in to this CRA “extortion.” Senator Phil Gramm (R-TX) inserted
a provision in the Gramm-Leach-Bliley Act in 1999 that required reports to
be filed disclosing any CRA “extortion” payments, in order to discourage
such activities.
These community activist groups were another part of the federal housing
policy that seeks to expand subprime lending regardless of the risks. This
support is carried out through the Community Reinvestment Corporation,
under the name NeighborWorks America. It is a congressionally chartered
public nonprofit corporation, chaired by a Fed governor. It seeks to increase
opportunities for families to live in affordable homes through networks of
local partnerships, which grew to include some 236 organizations operating
in more than 3,000 communities.
Among other things, NeighborWorks administers a program that pays
community organizations millions of dollars to provide counseling services
for distressed subprime borrowers. One such recipient was the Association

of Community Organizations for Reform Now (ACORN), a community

organization. ACORN’s Web site described itself as “the nation’s largest
grassroots community organization of low- and moderate-income people with
over 400,000 member families organized into more than 1,200 neighborhood
chapters in about 75 cities across the country.”7 Congress gave ACORN $25
million in 2009 to counsel subprime lenders with problems repaying their
mortgages, as part of a $333 million program for such counseling. About
2,700 such counselors were approved by HUD for this National Foreclosure
Mitigation Counseling program, which, in addition to ACORN, included the
Neighborhood Assistance Corporation, the Home Ownership Preservation
Foundation, and the National Foundation for Credit Counseling.
ACORN was at the center of the policies and programs that led to the mas-
sive increase in subprime lending but was accountable to no one. It was widely
engaged in political activities in support of liberal candidates and was closely
associated with the Obama presidential campaign. ACORN’s political activities
led to scandals over what was claimed to be its fraudulent registration of voters,
leading to numerous indictments in several cities across the country. Another
scandal arose in September 2009, after FOXNews broadcast an undercover
film in which two individuals pretended to seek counseling at ACORN offices
in Washington, DC, Baltimore, Maryland, and Brooklyn, New York. They
were seeking advice on how they could obtain a mortgage loan on a building
so that they could start a brothel. One ACORN representative suggested that
they use the term “performing arts” rather than the word “prostitute” on their
loan application when describing the female applicant’s profession. They were
advised on how to evade taxes and launder money. An ACORN representa-
tive further suggested that underage girls the filmmakers stated were being
imported for prostitution should be referred to as “exchange students.” One
ACORN representative even offered to help smuggle the girls into the United
States. ACORN could not survive that publicity and was disbanded in March
2010 after its funding dried up. That still left open the question of how such
an operation could be so deeply involved in national housing policy and be
funded by taxpayers.
Incredibly, the Democrats, led by Barney Frank (D-MA) were seeking to
extend the CRA to nonbanks in September 2010. Lending to illegal aliens
(“undocumented workers”) was another subprime favorite for activist groups.
These loans were made to individuals without a Social Security number, but
who did have an individual taxpayer identification number (ITIN). Several
large banks, including JP Morgan Chase, were making these loans. Citigroup
was making ITIN loans through a joint venture with ACORN. ITIN loans were
first made in 2003, but they ran into much opposition from groups opposing
illegal immigration. Efforts in Congress to pass immigration bills that would
recognize undocumented workers failed, and many lenders pulled out of the
program because of this controversy. The Mortgage Guarantee Insurance Corp.
(MGIC) also stopped insuring ITIN loans in 2007.

Down Payment Policies
NeighborWorks America adopted a model affordable mortgage that required

a down payment of only 5 percent. Significant down payments had long been
considered an important tool for ensuring repayment of loans. However, as
evidenced by the NeighborWorks proposal, that protection was being aban-
doned as a part of government and quasi-governmental policy:
In 1989 only 7 percent of home mortgages were made with less than 10 percent
down payment. By August 1994, low down payment mortgage loans had increased
to 29 percent. This trend continued unabated throughout the 1990’s so by 1999,
over 50% of mortgages had down payments of less than 10%. In 1976 the average
down payment by first time homebuyers was 18%, by 1999 that down payment had
fallen to 12.6%. In 1999, more than 5% of all residential mortgages had no equity
or had negative home-equity.8
The Federal Housing Administration (FHA) also lowered its standards

and required only a 3 percent down payment. In 2004, President George W.
Bush proposed a Zero-Down Payment Initiative that would have allowed
FHA loans with no money down. Congress failed to act on that proposal, but
a rising housing market obviated the need for such a program. “By 2005, a
remarkable 43 percent of all first time homeowners put zero down or took out
a mortgage in excess of the value of the home. If home prices were rising 10
percent a year, a zero down loan would gain a 10 percent equity stake in just
12 months. Or so the logic went.”9
Safety and Soundness Concerns
The Fed advised banks that CRA loans were to be made in a safe and sound
manner, but subprime loans are by definition unsafe and unsound because the
borrower has a poor credit history. The Fed has also argued that the CRA did
not cause the subprime crisis because many subprime loans were issued by
nonbanks and did not receive CRA credit.10 The staff of the FCIC also noted in
a preliminary report that various studies questioned whether CRA loans were
at the center of the defaults that occurred during the crisis and that subprime
lending had soared outside the CRA-based lending. However, those claims
ignore the fact that the CRA and government policy required and legitimatized
this lending by large banks that had avoided such loans in the past. As former
Fed chairman Alan Greenspan testified before Congress in October 2008: “Its
instructive to go back to the early stages of the subprime market, which has
essentially emerged out of the CRA.”11
Subprime lending increased by almost 40 percent between 1993 and 1998.
The amount of securitized subprime mortgages grew from about $11 billion
in 1994 to more than $140 billion in 2002.12 The share of subprime loans
increased from less than 5 percent of home mortgages in 1994 to almost 20

percent in 2007. Subprime loan volume in the United States was estimated to
be about $90 billion in 1995, and it expanded to $175 billion in 1998. That
amount more than doubled by 2007. The government opened the door to
the subprime market, pushed the banks through, and the banks then gorged
themselves on what they believed to be a legitimate, socially responsible busi-
ness for which they could model and hedge for its inherent risk. As former
Senator Gramm opined: “It was not just that CRA and federal housing policy
pressured lenders to make risky loans—but that they gave lenders the excuse
and regulatory cover.”13
Historically, subprime and Alt-A loans were more costly to the lender to
originate, to sell, and to service than conventional prime loans, and posed
greater credit risk. Nevertheless, after being forced into the market by the gov-
ernment, investment banks soon found the business to their liking. Subprime
lenders were initially non-banks until the CRA pushed the large banks into
that market. There were only ten lenders in the subprime market in 1994, but
that number increased to fifty by 1998. By 2001, ten of the twenty-five largest
subprime lenders were banks or their affiliates. Investment banks like Merrill
Lynch and Bear Stearns also became competitors in this market, spreading
the cancer even further into the financial system.
The banks found that subprime loans had their attractions. As with other
mortgages, the lender made profits based on the spread between the funds it
borrows and those it lends to the subprime borrower. Subprime interest rates
had a spread of 300 or more basis points over conventional loans, and the
high origination and other fees charged for subprime loans tempted lenders
to originate large amounts of subprime loans. However, the default risk was
traditionally considered too high for the conventional commercial and invest-
ment banks. They solved that problem through securitization, which made
meeting CRA pledges easy and encouraged banks to plunge deeply into this
market to meet their CRA quotas and carry out their merger programs.
Freddie Mac and Fannie Mae Quotas
Subprime lending was accelerated by the pressure placed on Freddie Mac

and Fannie Mae by the Clinton administration to extend their operations into
subprime mortgages. Fannie Mae and Freddie Mac were also pushed into the
subprime business by Congress, which, in 1992, set specific volume goals for
subprime lending by those GSEs for 1993 through 1995. Thirty percent of units
financed were required to be for low- to moderate-income borrowers, and 30
percent had to be for properties located in large cities. In addition, these GSEs
were required to make $3.5 billion in loans to subprime borrowers. These
programs added new risks to the already complicated portfolios of these two
GSEs. In 1996, HUD secretary Henry Cisneros mandated that Fannie Mae
and Freddie Mac meet a quota in which 42 percent of their loan purchases
and guarantees had to be for low- and middle-income families. In November

1999, Fannie Mae vice chair Jamie Gorelick announced, with much fanfare,
that Fannie Mae would make $18 billion available in New Jersey alone for
subprime loans, including those for no money down.
The Clinton administration’s role in the subprime crisis did not pass entirely
unnoticed. Cisneros was the subject of a front-page article in the New York
Times on October 19, 2008, charging him with unleashing the subprime crisis
by extending government loan programs to borrowers who could not afford a
mortgage. After leaving the government, Cisneros was elected to the boards
of KB Homes and Countrywide Financial Corporation, one of the nation’s
largest home builders and one of the largest subprime mortgage lenders, re-
spectively. Countrywide was a leading lender of subprime mortgages and had
to be rescued during the subprime crisis by Bank of America, which in turn
was bailed out by the taxpayers through TARP. KB Homes suffered massive
losses during the subprime crisis and was accused by the Justice Department
of misconduct in sales programs.
At Fannie Mae, Franklin Raines expanded subprime exposure by loosening
credit requirements. He had disparaged the risks of subprime lending by Fannie
Mae, asserting in 2003 that its risk-based capital requirement would “protect
us from failure under extreme interest rate changes, sustained, Depression-era
credit conditions and catastrophic operations or management failure.”14 He
noted that, even though it was a privately owned company, Fannie Mae was
“an instrument of national housing policy.”15 He boasted that both Standard
& Poor’s and the Corporate Library had given Fannie Mae high marks for its
corporate governance structure.
During his tenure at Fannie Mae, Raines expressed pride in the fact that
Fannie had reduced the size of mortgage down payments from 10 to 20 percent
of home value to $500. He was also pleased that many lenders were making
loans with no down payment. He was equally proud of the fact that Fannie
Mae had launched an American Dream Commitment to provide $2 trillion in
subprime mortgages in the first ten years of the twenty-first century, which
it soon increased by another $300 billion. Raines stated in 2003: “No single
company in America provides more mortgage funds to underserved [subprime]
families than we do. That, I believe, is the true test of whether we lead the
market.”16 It was also the formula for the failure of Fannie Mae and Freddie
Mac, as well as nearly destroying the nation’s economy.
In September 1999, Fannie Mae announced an easing of lending require-
ments on subprime mortgage loan applications in order to increase homeowner-
ship rates for low-income borrowers. The program was intended to encourage
banks to make loans to such borrowers, even though they were not able to meet
the standards required for conventional loans. In another act of recklessness,
Fannie Mae reduced down payment requirements.
Over the past decade Fannie Mae and Freddie Mac have reduced required down
payments on loans that they purchase in the secondary market. Those requirements

have declined from 10% to 5% to 3% and . . . Fannie Mae announced that it would
follow Freddie Mac’s recent move into the 0% down payment mortgage market.
Although they are buying low down payment loans, those loans must be insured
with “private mortgage insurance” (PMI). On homes with PMI, even the closing
costs can now be borrowed through unsecured loans, gifts or subsidies. This means
that not only can the buyer put zero dollars down to purchase a new house but also
that the mortgage can finance the closing costs.17
Fannie Mae and Freddie Mac also ignored economics and sound business
practices in order to further subprime growth. Fannie Mae subprime loans
were issued at only one percentage point above that of a conventional thirty-
year fixed mortgage, rather than the three- or four-point spread required for
private market subprime loans. This meant that it was not being adequately
compensated for this risk.
Andrew Cuomo
Andrew Cuomo succeeded Eliot Spitzer as a crusading New York attorney

general. Cuomo had run unsuccessfully as a Democratic candidate for governor
of New York in 2002. Cuomo was a lackluster campaigner who needed some
pizzazz in order to resonate with voters. He decided not to seek the nomination
for governor in 2006 because Eliot Spitzer had announced his candidacy and
appeared unbeatable. Cuomo then ran for the post vacated by Spitzer as New
York attorney general. Cuomo won that election, but it was the closest state-
wide election in a year when Democrats swept the Republicans from office.
Cuomo, nevertheless, was now positioned to follow Spitzer as governor in a
future election, provided that he could garner sufficient publicity as a crusading
attorney general, with Wall Street providing the perfect target and headline
generator. Although Cuomo lacked much of Spitzer’s rancor, he was just as
aggressive as Spitzer in seeking headlines from Wall Street prosecutions.
Cuomo continued Spitzer’s expansive application of the Martin Act, which
had been passed in the 1920s in New York to stop fraudulent securities opera-
tions but lay largely dormant until Spitzer arrived. In one remarkable instance,
Dynegy was the target of Martin Act charges brought by Cuomo on grounds that
it had not properly disclosed the carbon emissions from coal-fired power plants
that Dynegy planned to build. Those plants were viewed by the green crowd of
Democratic supporters as a leading contributor to global warming, hence the
Cuomo campaign against Dynegy. Cuomo was joined by former vice president
Al Gore, the leader of the climate change movement, in announcing that Dynegy
agreed to a settlement in which it would disclose in its SEC filings risks relat-
ing to climate changes and its carbon emissions. Why Gore was present for the
settlement of a state prosecution and why Cuomo dictated what should go into
SEC financial reports were unasked and unanswered questions.
Cuomo was front and center during the subprime crisis with high-profile
(and well-publicized) investigations of auction rate securities, student loan

practices, and bonuses at Merrill Lynch and other firms receiving federal
government bailout money, to name a few. Like Spitzer, Cuomo became a
branch of government unto himself, often displacing the SEC as the regulator
of Wall Street. But the consuming question is: What have these prosecutions
accomplished beyond headlines for Cuomo? A case in point was the separate
actions brought by the SEC, Cuomo and the North Carolina attorney general
against Bank of America and its CEO Kenneth Lewis. Those actions charged
fraud in failing to disclose some unexpected losses at Merrill Lynch before
the shareholder vote to approve its merger with Bank of America. Govern-
ment resources were being squandered to bring multiple actions for the same
conduct, but no matter, Cuomo’s action brought him front-page headlines and
raised his profile in the 2010 gubernatorial race.
The auction rate security cases forced brokerage firms to cover the losses
of investors, but served merely as a forced bailout of their frozen investments.
This set the unfortunate precedent of making brokers guarantors of the securi-
ties that they sell. Most firms caved in to Cuomo’s intimidation and paid up
without protest. However, Cuomo may have gone too far when he attacked
discount brokers, like Charles Schwab, who sold auction rate paper. Those
discount brokers do not make recommendations and do not underwrite auc-
tion rate securities. Schwab decided to challenge Cuomo’s overreaching by
refusing to enter into the customary settlement.
There is some irony present in Cuomo’s subprime crusades. The son of
former governor of New York Mario Cuomo and the former husband of Kerry
Kennedy (a daughter of Robert Kennedy), Cuomo served on his father’s staff
in the governor’s office and founded a not-for-profit company called Hous-
ing Enterprise for the Less Privileged (HELP). That role laid the groundwork
for him to serve in the Department of Housing and Urban Development from
1993 until 2001, rising to become its head in 1997. As HUD secretary, Cuomo
increased the subprime quota for Fannie Mae and Freddie Mac to 50 percent in
2000.18 This allowed Cuomo’s attorney general Web site to boast that “under
his leadership, HUD was transformed from a bureaucratic backwater rife with
waste to a revitalized engine for housing development.”19
Bush Administration
The policy of extending subprime lending was carried forward by the Bush
administration, which added some fuel to the fire through the passage of the
American Dream Down Payment Assistance Act, which was signed into law on
December 16, 2003. This legislation authorized as much as $200 million annu-
ally to be given to low-income, first-time homebuyers, in order to allow them to
make a down payment and to pay closing costs. The assistance provided could
not exceed $10,000, or 6 percent of the purchase price of the home, whichever
was greater. In 2002, President Bush announced that his administration intended
to increase the number of minority homeowners by 5.5 million.

Freddie Mac and Fannie Mae increased their role in the subprime market
in 2002, after being urged to do so by the Bush administration. They were
pressured to make such loans in 2004 by HUD, which required Fannie Mae
and Freddie Mac to make a higher percentage of their loans to low-income
borrowers. Fannie Mae and Freddie Mac tried to meet those requirements by
investing in privately created structured investment vehicles (SIVs) that were
triple-A rated.
Even though the default rate on subprime loans was six times higher than
that of conventional loans:
By 2005, HUD required that 45 percent of all the loans bought by Fannie Mae and
Freddie Mac be loans to borrowers with low and moderate incomes. HUD required
further that Fannie and Freddie buy 32 percent of the loans in their portfolios from
people in central cities and other underserved areas and that 22 percent of the
loans they buy be to “very low income families or families living in low-income
neighborhoods.”20
Between 2002 and 2007, $2.6 trillion in subprime mortgages was generated,
representing about 20 percent of all mortgages. This growth was spurred by
increases in acquisition and securitization by Fannie Mae and Freddie Mac.
This figure did not provide the whole picture of the risks injected into the
system. Loans rated just above subprime were classified as Alt-A loans. The
borrower in an Alt-A had an above-subprime FICO score, but the loan had a
defect such as little or no documentation (“no-doc” or “low-doc” loans) of the
borrower’s creditworthiness. In “stated-income loans,” borrowers were allowed
to state their income without documentation, earning them the sobriquet of
“liar loans.” By 2006, 40 percent of new mortgage originations were either
subprime or Alt-A.
Clearly, government housing policy was the basis for the explosive growth
in the subprime market. As one commentator noted:
It was government policy for these poor quality loans to be made. Since the early
1990s, the government has been attempting to expand home ownership in full
disregard of the prudent lending principles that had previously governed the U.S.
mortgage market. Now the motives of the GSEs fall into place. Fannie and Fred-
die were subject to “affordable housing” regulations, issued by the Department of
Housing and Urban Development (HUD), which required them to buy mortgages
made to home buyers who were at or below the median income. This quota began
at 30% of all purchases in the early 1990s, and was gradually ratcheted up until it
called for 55% of all mortgage purchases to be “affordable” in 2007, including 25%
that had to be made to low-income home buyers.21
Interest Rate Policies
Fed interest rate policies have proved a failure in the twenty-first century.
This shortcoming actually stems from an earlier success. In 1982 the then-Fed

chairman, Paul Volcker, stepped in to apply some harsh medicine in the form
of unprecedentedly high interest rate increases in order to curb rampant infla-
tion. Volcker’s actions sent the country into a deep recession. Nevertheless,
the economy recovered and entered a new era of prosperity. Volcker’s actions
were seared into the minds of future Fed chairmen, influencing them to guard
against inflation even at the risk of a serious recession. They also convinced
the Fed that it could control the economy through interest rate hikes to stunt
inflation or deflate bubbles and interest rate cuts to boost the economy when
it appeared headed toward recession.
Interest rate policy has proved a very blunt instrument that must be
wielded with skill and finesse, two traits lacking in government. These rate
policies have an identifiable effect on markets, to which the Fed has seemed
oblivious. For example, the Fed increased short-term interest rates for the
first time in five years in February 1994, causing turmoil in the bond market
and resulting in massive losses totaling hundreds of billions of dollars. In
particular, collateralized mortgage obligations (CMOs) were crushed by these
increases because they slowed mortgage repayments, extending the average
maturity of CMOs, and damaging their investors. As a result, the market
in CMOs collapsed and sizeable losses were suffered by several large Wall
Street financial firms.
The Fed switched course in 1995 and dictated low interest rates to spur a
lagging economy, setting off a bubble in the stock market. After that bubble
was well under way, the then-chairman Alan Greenspan suggested that the
market could be influenced by “irrational exuberance,” and later rapidly raised
interest rates. This caused a precipitous disruption in the stock market in 2000
and crippled the economy in 2001. The Fed then dramatically slashed interest
rates, pumped up liquidity, and set off another bubble in the residential housing
market. The real estate bubble was then popped by the Fed through another
dizzying series of rate increases that sent the economy into a near-fatal tailspin.
Interest rates have been slashed once again, even more dramatically to near
zero during the subprime crisis, and the process will undoubtedly start anew
once the economy shows signs of recovery.
Targeted Interest Rates
In the off-season, that is, when it is not involved in an economic crisis, the Fed
focuses on inflation and has grand debates over “targeted” inflation rates. The
eruption of an economic crisis causes concerns over inflation to be abandoned,
but not until much damage has been done to the economy. This approach is
wrongheaded and must be corrected by adding more certainty to the process
that would allow better business and economic planning. The Fed needs to
identify the “normal” rate of interest, which it can lower or raise gradually,
according to a prescribed formula, as inflation or other economic conditions
dictate, but always with a view to returning to the equilibrium, “normal” inter-

est rate target. This will allow businesses to plan for increased, or decreased,
interest rates without having to read the tea leaves to determine what the Fed
will do in any given circumstance.
The Fed certainly has a role to play in fighting inflation, as proved by Vol-
cker in the 1980s, but more certainty could be added by indexing the interest
rate to the rate of core inflation. This would, once again, allow more flexible
financial planning when inflation is on the rise. This is not a new idea. John
Taylor, a Stanford economics professor, posited the “Taylor Rule,” which cre-
ated a formula for “setting interest rates that depended on where inflation was
versus the Fed’s goal for it, how far from full employment the economy was
and what the short term rate should be when the economy was perking along.”22
Economist Robert Barbera has also proposed a formula for interest rates that
would account for changes in credit spreads as well as inflation. Something
along these lines would be better than the present roller coaster approach.
Although the effects of interest rate changes are not visible for some months,
the Fed typically imposes a series of rapid interest rate changes in order to
obtain a quick result, but inevitably, the Fed goes too far, stalling the economy
or inflating a bubble. The Fed funds target rate was lowered to near zero in the
subprime crisis. The only guidance on the Fed’s future course on rates was
Fed chairman Bernanke’s statement that rates will stay low for an “extended
period,” which is generally interpreted as meaning at least a period of several
months, but nothing more.
What is needed is firm guidance based on a recognized formula, so that
financial markets can plan and adjust to changes in a rational fashion. For ex-
ample, Bernanke could announce that the Fed and economists are forecasting
a recovery in, say, mid-2011, and, therefore, the market should expect quar-
terly interest rate increases starting in, say, December 2011, at a rate of 0.25
percent, until the targeted “normal” rate (for example, 3 percent) is reached.
He could further advise that the Fed will then pause and will not raise rates
further, except in accordance with the prescribed inflation formula. This will
remove the Fed from its role of managing the economy, a task that is beyond
its abilities. It will allow for planning by investors and institutions exposed
to interest rate risks.
Carry Trades
Subprime loans were often funded by the lender at short-term rates and then
lent to the subprime borrower at higher long-term rates. This allowed a profit
from the spread between the two because long-term interest rates are normally
higher than short-term rates. As long as yield spreads were constant, that
spread created a steady stream of profits from the collateralized debt obliga-
tions (CDOs) created to fund subprime mortgages. However, that advantage
became a liability when short-term interest rates rose faster than long-term
rates, cutting that profit margin. That is exactly what happened when the Fed

raised short-term interest rates, with seventeen straight increases between June
2004 and June 2006. CDOs funded with short-term commercial paper were no
longer viable, and refunding became a problem with the arrival of the credit
crunch in 2007. Had there been a stated policy on interest rate increases, the
danger from this carry trade could have been more readily anticipated.
Banks are also affected by mismatches between short- and long-term inter-
est rates. As one writer noted:
The lesson drawn from the Panic of 1907 that led to the creation of the Fed was that
banks play a unique and a vital role in the economy: they take deposits and bor-
rowed short-term (the savings of a society), and they lend money for the long-term
to finance the investments of the society. The mismatch between taking money that
can be withdrawn at any time and lending it in ways that will be paid back only
over time make them vulnerable. So they are required to set aside some money
for emergencies, maintain substantial capital cushions to absorb losses, submit to
government regulation to restrain from taking imprudent risks, and are offered the
privilege of borrowing from the Fed in a crisis.23
This regulatory bargain is broken by the Fed when it squeezes the yield curve
through inordinate short-term interest rate increases that the banks cannot plan
for, or react to, in sufficient time to protect themselves. They are then helpless
and dependent on the Fed for liquidity. Reducing interest rates in times of crisis
also leads to other carry trade concerns. China, for example, criticized the Fed in
November 2009 for allowing investors to borrow funds at extremely low rates in
order to buy higher-yielding assets abroad. Germany had issued a similar warning
earlier. The Fed concluded in November, however, that the risk that low interest
rates would encourage excessive risk taking was relatively low.
The Fed’s Liquidity Role
A central bank’s crucial role in the economy is, as advocated by Walter Bagehot
in the nineteenth century, that of providing liquidity in times of need. That role
was fulfilled by the Fed and the Treasury Department, with some exceptions,
heroically during the subprime crisis. Economist Anna Schwartz accused the
Fed of failing to recognize and to deal with the fundamental breakdown in the
economy during the Great Depression—the lack of liquidity in the financial
system. Bernanke and Paulson were determined not to repeat that mistake dur-
ing the subprime crisis. Although proving once again that you cannot please
everyone, Schwartz accused Paulson and Bernanke of engaging in a rogue
operation in making loans to save Bear Stearns.
The government bailout and emergency loan facilities created by the bank
regulators included the following.
1. increased use of the Fed discount window, increasing the amount of

loans in that facility from $1.3 billion in September 2007 to $125
billion in June 2009;

2. the $700 billion Troubled Asset Relief Program (TARP) bailout package;
3. creation of the twenty-eight-day (and later eighty-four-day) Term
Auction Facility (TAF), which increased from its initial $20 billion
auction on December 17, 2007, to $421 billion in outstanding loans
at the end of 2008;
4. Term Securities Lending Facility (TSLF), which extended the over-
night borrowing facility available to primary dealers to loans with a
tenure of twenty-eight days and allowed them to post illiquid collateral
for that borrowing; that facility grew from $20 billion in borrowings
in December 2007 to $150 billion in May 2008. It was closed on
February 1, 2010;
5. the Asset-Backed Commercial Paper (ABCP) Money Market Mutual
Fund Liquidity Facility (AMLF), which made nonrecourse loans on
ABCP commercial paper in order to curb the panic in money market
funds after the failure of the Reserve Primary Fund; this facility was
closed on February 1, 2010;
6. the Commercial Paper Funding Facility (CPFF), created on October
7, 2008, to purchase unsecured ABCP from corporate issuers through
a special purpose vehicle (SPV); by December 31, 2008, this program
had purchased $334 billion in assets. It too was closed on February 1,
2010;
7. the Money Market Investor Funding Facility (MMIFF), established
on October 21, 2008, to purchase up to $600 billion in assets from
money market funds; this little-used facility was allowed to expire in
June 2009;
8. the $600 billion Mortgage-Backed Purchase Program, created on
November 25, 2008, to purchase $500 billion in direct obligations
of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks
(FHLBs); that sum was increased to $1.25 trillion on March 18, 2009,
and by June 2009, $427 billion of those purchases had been completed.
The Fed completed its purchases under this program on March 31,
2010;24
9. expanded currency swap lines with foreign central banks, whose
outstanding notional amount rose to $614 billion in December 2008
before declining to $176 billion in June 2009;
10. payment of interest on bank reserves held at the Fed;
11. the Federal Deposit Insurance Corporation (FDIC) Temporary Liquid-
ity Guarantee Program (TLGP), which guaranteed debt issued by
thrifts and banks with tenors ending by 2012; about $320 billion in
debt was guaranteed under this program as of July 2009. This program
is set to expire on December 31, 2010;
12. expansion of the FDIC account insurance maximum coverage amount
from $100,000 to $250,000 in October 2008, which was made per-
manent in 2010; and

13. the $200 billion Term Asset-Backed Securities Loan Facility (TALF),
expanded on March 3, 2009, to $1 trillion, which makes secured,
nonrecourse loans available to banks and commercial firms, includ-
ing hedge funds, using as collateral such things as credit card debt,
consumer loans, and student loans.
In addition to these programs was the $168 billion stimulus package signed
into law by President Bush on February 13, 2009, and the $787 billion stimu-
lus package signed into law by President Obama almost one year later, on
February 17, 2009.
“Helicopter Ben” and “Hank the Bazooka”
Fed chairman Bernanke had once praised the economist Milton Friedman for
his statement that the government could stop deflation by dropping money
from helicopters. That praise led Bernanke to be referred to as Helicopter Ben,
a role he would fulfill grandly during the subprime crisis, along with Treasury
Secretary Henry Paulson and Federal Reserve Bank of New York President
Timothy Geithner. Paulson was a somewhat awkward statesman, but he was
sincere in seeking funding from Congress that would convert his “squirt gun”
ability to rescue financial institutions into a “bazooka” that would increase
confidence in the market.
This triumvirate appeared to have made one serious misstep in declining
to rescue Lehman Brothers, a shortcoming that set off the Great Panic in the
fall of 2008. However, they quickly reversed course and saved American In-
ternational Group (AIG) and backed the money market funds in order to stop
the panic. Another misstep occurred when Paulson and Bernanke decided to
convert TARP from purchasing troubled financial assets from financial insti-
tutions to a capital injection program like the one used by the Reconstruction
Finance Corporation in the 1930s, which failed so miserably. To be sure, TARP
had a stabilizing effect, but it also touched off a populist crusade against large
financial institutions that resulted in more costly regulations. Asset purchases
under other Fed and Treasury programs did not receive similar opprobrium.
Otherwise, Bernanke, Paulson, and Geithner’s efforts were a model of
effective operation by a central bank and Treasury during a financial crisis.
Nevertheless, the debate continues to rage over whether the federal government
created a dangerous moral hazard in treating some financial institutions “as
too big to fail.” Critics said that, instead of being the lender of last resort, the
Fed had become the pawnbroker of last resort. An even more extreme view
was expressed during the 1930s by Treasury Secretary Andrew Mellon, who,
according to President Herbert Hoover, preached: “Liquidate labor, liquidate
stocks, liquidate the farmers, liquidate real estate.”25
What is clear from this and earlier financial crises is that the government
behaves erratically and unpredictably. Sometimes, it steps in to save a particu-

lar firm, like Continental Illinois, but allows another one, like Penn Square or
Drexel Burnham, to fail. In other instances, as when Enron was in extremis,
the government turns its back on a faltering company because to save it would
have been politically unpopular, even though its failure might have long-term
economic consequences. Such uneven treatment was even more glaring during
the subprime crisis. Bear Stearns, Merrill Lynch, Wachovia, and others were
saved by shotgun marriages, while Citigroup, Bank of America, and AIG were
simply bailed out with government cash. In contrast, Lehman Brothers was
left to fail, touching off a worldwide panic.
The policy debate on this issue has been unfocused. One group of critics
contends that there should be no government bailouts. They would leave
failure and success to the market. Many critics of bailouts view the cyclical
turns in the market and economy as beneficial, a form of “creative destruction”
necessary to advance society. Others want stability at all costs. They want an
economy that they need not fear. Some critics would allow bailouts of finan-
cial services firms in order to avoid panics, while others would use bailouts
only to rescue faltering industries, such as the automobile industry. Paulson
and Bernanke tried to steer a middle course between those two extremes and,
while their actions were uneven, they succeeded in preventing a complete
collapse of the economy.
Since at least 1790, the government has sought a formula or mechanism to
prevent panics and economic downturns. Like the search for a cure for cancer,
that effort has not been entirely successful. It is unlikely that a formula can be
devised for scientifically choosing whether, or which, firms should be bailed
out. The present ad hoc decision making seemed to work about as well as could
be expected. Market participants were left with a lot of uncertainty over whether
they will be bailed out if they overextend themselves. The government was
left with the uncertainty of knowing that if it bails out too many firms, market
discipline will falter. Conversely, if it does not bail out a firm that truly raises
systemic concerns, like Lehman Brothers, a panic might develop. As will be
seen, legislation that was passed in July 2010 sought to give some structure
to this process, but it only served to make the decision-making process more
unwieldy and bureaucratic. This is unfortunate because time and decisive
decision making are crucial in a financial crisis.
Capital Requirements
Bank capital requirements became the focus of regulatory concern during

the subprime crisis. Seeking to close the barn door while the horses were
still bolting, the European Union was considering a revamping of its capi-
tal requirements in October 2008 at the height of the subprime crisis. The
proposals included provisions to improve management of large exposures
by banks from securitizations and purchases of collateralized debt, such as
the subprime mortgages that had caused such massive losses to European

banks. The European Union also considered a proposal to create a “college of

supervisors” to oversee cross-border banking groups, including those in the
United States with subsidiaries in Europe. The EU further sought to improve
the quality of bank capital. Jean-Paul Redouin, first deputy governor of the
Banque de France, had a more astute interpretation of which reforms were
needed. He charged in October 2007 that the subprime crisis had revealed a
need to revise how risks are analyzed for new financial products. He also urged
the development of a new and common framework for evaluating risks from
complex structured products.
The Basel Committee on Banking Supervision sought, in April 2008, to have
banks increase their capital to support structured products and off-balance-sheet
special-purpose entities, which at the time were causing much of the loss from
subprime mortgages. The Basel Committee also announced on November 20,
2008, a revision of the Basel Accord (Basel III) in order to strengthen the cap-
ture of risk from trading assets and off-balance-sheet exposures. This would
involve capital set-asides for collateralized debt obligations (CDOs). It sought
to enhance the quality of Tier 1 capital by adding additional shock absorbers
that could be drawn down during periods of stress and reduce pro-cyclical
capital demands. The committee considered whether its risk-based measure-
ment system should be supplemented by fixed gross measures of exposure in
prudential and risk management systems in order to limit leverage.
The Basel Committee agreed at the Group of Twenty meeting in September
2010 to require their banks to substantially raise their capital levels (from 2
percent to 7 percent of risk weighted assets) and quality. At least half of required
equity would have to be from common stockholders and retained earnings.
It was expected that this requirement would fall most heavily on European
banks. Bank supervisors would also be allowed to curb dividends and stock
buybacks that could deplete capital. However, bank regulators ultimately
agreed to phase in those stricter standards starting in 2013.
The Obama administration had proposed in June 2009 increasing capital
requirements for large financial institutions and requiring banks to hold a portion
of the loans that they originate on their own books. For reasons that were unclear,
the new regulatory proposals also sought to require industrial loan companies
to become bank holding companies subject to stringent federal regulation and
capital requirements. These companies were often used by distributors, like
Target, to provide financing for the sale of their goods to consumers. These
industrial loan companies operated under state charters with only loose regula-
tion. It was expected that many of these industrial loan companies would be
shut down if they were to be regulated like banks because of the high cost of the
new regulation. Those closures would make it harder for consumers to obtain
credit and make it harder for these companies to sell their goods. Legislation
passed in July 2010 imposed a moratorium on new FDIC insurance applica-
tions for industrial banks, credit card banks, and trust banks.
Bernanke had added more fuel to the fire in October when he advised the

banking industry that the Fed would focus on capital requirements as a way
of preventing future crises. He considered a capital surcharge for large banks,
increases in Tier 1 capital, and “contingent” capital, debt that converted to com-
mon stock in times of stress. The International Monetary Fund joined the chorus
in April 2010 by advocating customized higher capital requirements for banks
posing systemic risk. However, the Group of Twenty nations had agreed at their
conference in Toronto on June 27, 2010, to delay implementation of more strict
capital charges for banks for several years, and regulators agreed to reduce those
requirements because of concern over continuing economic weakness.
Further talks in Basel in July 2010 resulted in a general agreement (Germany
dissenting) that core capital should be redefined to limit non-traditional equity
items to 15 percent of total capital. State insurance regulators in the United
States also announced that they were backing down from a proposal that
would have imposed steep capital charges for insurance companies investing
in mortgage-backed securities.
This focus on revising bank capital requirements underscores an unfortu-
nate truth, which is that regulators are powerless to prevent financial crises.
International bank regulators spent years developing the Basel I and Basel II
capital requirements for banks, but those mandates failed to prevent many of
the largest banks from leveraging themselves into a position that threatened
their viability. Indeed, subprime lending by the regulated banks was actu-
ally encouraged by the Basel capital requirements, which were amended by
regulators in the United States in 2001 to allow much reduced capital require-
ments for mortgage-backed instruments that were rated AA or triple-A. Those
capital requirements were much lower than those for individual mortgages or
for commercial loans. As one commentator noted, the banks reacted to that
inducement by purchasing large amounts of securitized mortgages.26
Another problem with capital requirements was that regulators sent mixed
messages to the banks as the subprime crisis peaked. Banks were urged to lend
the funds supplied by the federal government under its bailout program. At
the same time, bank regulators pressured the banks to increase their capital,
requesting that Tier 1 capital be increased from 6 percent to 8 percent and
that core capital be increased from 10 percent to 12 percent. However, those
increased requirements removed funds needed for lending operations and thus
added to the ongoing credit crunch. A similar thing happened in 1937 when the
Fed doubled bank reserve requirements, helping to stop a nascent economic
recovery. Capital-requirement increases should be countercyclical in order to
avoid adding additional strains on the financial system in times of crisis.
The Treasury Department recognized this point and issued a policy statement
in September 2009 on increasing capital requirements. The statement declared
that in the future new requirements would be countercyclical, requiring banks
to increase capital in good times, so that it would be available in downturns.
Financial reform legislation that was passed in 2010 now requires that capital
requirements be countercyclical so that the amount of capital required increases

in times of economic expansion and decreases in times of economic contraction.

During the subprime crisis and its aftermath, however, banks were required
to raise capital in extreme market conditions, impeding their ability to do so
and only at a high cost.
The Treasury Department further suggested a simple leverage ratio for
banks, which the FDIC had long advocated, and which would include off-
balance-sheet items. Common equity would also be required to constitute
a large majority of the banks Tier-1 capital. Those recommendations were
included in the financial services legislation that was passed in July 2010.
The Treasury Department did not envision applying any increased capital
standards for some time because of the weakened condition of many banks.
The FDIC announced in the wake of the subprime crisis that it would propose
a cap on interest rates that undercapitalized banks could pay for deposits. This
seemed to be a return to the days of interest rate caps that are unworkable in
times of inflation.
An internal report prepared by JPMorgan predicted that the profitability of
large banks would be reduced by one-third if the capital and other regulations
sought by the Obama administration were adopted. This is the crux of the
problem. Financial institutions are, for the most part, highly leveraged, which
means that they borrow money to finance their activities. Capital requirements
do not deleverage banks; those requirements only restrain some leverage. In
order to really deleverage the banks, capital requirements would have to be
so high as to cause their exit from the business, or they would have to turn
themselves into hedge funds where they could operate a leveraged business.
Financial engineers may, however, have come up with a solution in the form
of contingent convertible bonds (CoCos), which convert to equity when a bank
becomes undercapitalized, thereby increasing the equity base and reducing
creditor demands on assets.
SEC Capital Requirements
A problem began to develop with the new bank capital proposals as part of a
long-running battle between the Securities and Exchange Commission (SEC)
and bank regulators over bank loan loss reserves. The SEC was concerned
that banks were creating excess reserves and using them as “cookie jars” to
smooth earnings. Bank regulators, however, liked excess reserves; the more
excess the better in their view, because those reserves can be used to offset
losses in a downturn. The SEC had also stopped banks from creating secret
reserves for use in market downturns, a common practice of foreign banks.
That action was taken in the name of full disclosure, but it only weakened
the banks.
The SEC’s own minimum net capital program for broker-dealers was in
tatters. After the failures of Merrill Lynch, Bear Stearns, and Lehman Brothers
during the subprime crisis, the SEC came under severe criticism for failing to

recognize that the internal risk management systems of these broker-dealers

failed to anticipate or model for dramatic market movements found in the “fat
tails” in their bell curves. The SEC, pursuant to an EU directive, had allowed
large broker-dealers to become “consolidated supervised entities” (CSEs) that
did not have to comply with its net capital rule. Rather, such entities could
use their own internal risk models for determining their capital needs. CSE
status freed up capital for the large firms, but at the same time it reduced their
cushion when losses were sustained. Of course, the CSE risk models were
not the only ones with a flaw. Most risk models, including those in use by
banks under Basel II, failed to identify the risk from fair-value accounting
requirements that required CDOs to be marked down to fire-sale levels. Like
the CSEs, large banks experienced massive losses from subprime exposures
during the crisis. It is also notable that the squadrons of bank examiners
employed by bank regulators failed to spot the dangers posed by the Super
Senior subprime CDOs.
The SEC admitted on September 26, 2008, that its CSE program was a
failure and dropped it. By that point, no such entities were left to supervise.
The only surviving CSEs, after the failures of Bear Stearns, Merrill, and Leh-
man, were Goldman Sachs and Morgan Stanley. However, those two entities
converted to bank holding company status during the subprime crisis so that
they could access Fed lending facilities. Bank regulators then became the
primary regulators for Morgan Stanley and Goldman Sachs, rather than the
SEC. The SEC’s own inspector general found deficiencies in the way that
the SEC monitored broker-dealers using the CSE risk-based capital system.
The inspector general concluded that the SEC had failed to properly monitor
large financial services firms as required by the Market Reform Act of 1990,
which was passed after the holding company in the Drexel Burnham Lambert
complex raided funds from its regulated broker-dealer in an unsuccessful ef-
fort to stave off bankruptcy.
Some new securities market capital proposals seemed a bit extreme. In
2009, the industry’s self-regulatory body, the Financial Industry Regula-
tory Authority (FINRA), proposed changes to its rules that would allow
its executive vice president to unilaterally order large brokerage firms to
increase their net capital when deemed necessary for investor protection.
Critics charged that this was a very dangerous proposal because it would
allow that individual to put larger brokerage firms out of business with a
unilateral demand for increases in capital when the firm was stressed and
its ability to raise capital limited.
Fair-Value Accounting
“The difficulty in putting a value on loans, securities, and exotic financial

instruments banks were carrying on their books became one of the most debili-
tating features of the Great Panic” in 2008.27 The adoption of a mark-to-market

accounting requirement for subprime securities, which wreaked havoc during

the subprime crisis, seems strange. Mark-to-market, or “fair-value” account-
ing, was expanded by Enron, which used it to inflate its earnings in order to
run up its stock price. Equally interesting is the fact that regulators resolutely
resisted easing fair-value accounting requirements during the subprime crisis
despite their crippling effect on major financial services firms.
“What many people do not realize is that mark-to-market accounting existed
in the Great Depression and, according to Milton Friedman, was an important
reason behind many bank failures. In 1938, Franklin Delano Roosevelt called
on a commission to study the problem and the rule was finally suspended.”28
Even earlier, the Reconstruction Finance Corporation (RFC) dropped fair-value
accounting requirements in order to restart the banking system by allowing
troubled banks to join the FDIC. Instead, the RFC “deemphasized the liquidity
and marketability of bank assets, and evaluated high-grade securities at their
potential, not market, value. The RFC gave book or cost value to the highest
grade bonds, market value for bonds in default, face value for slow but sound
assets, and a reasonable valuation for doubtful assets like real estate.”29
Historical-cost accounting was widely embraced during and after the Great
Depression because of its perceived conservative approach to valuation. Robert
E. Healy, one of the first of the SEC commissioners appointed by Franklin
Roosevelt, conducted a lengthy investigation into questionable accounting
practices, including improper asset write-ups. Healy became an advocate of
historical-cost accounting for assets on the balance sheet, which was adopted
into generally accepted accounting principles. However, mark-to-market ac-
counting began to reappear during the 1970s. In December 1975, the Financial
Accounting Standards Board (FASB) issued FAS 12, which required companies
to record their marketable equity securities at the lower of their cost or their
mark-to-market value.
That directive was followed by others that expanded the use of fair-value
accounting for tradeable instruments. For example, in 1998, the FASB issued
FAS 133, which imposed fair-value reporting requirements on the valuation
of derivative contracts. The FASB issued FAS 157 in 2006, which defined fair
value as the price received in the sale of an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement date.
The problem during the subprime crisis was that the market was not orderly
due to the panic among investors that allowed subprime instrument sales only
at fire-sale prices.
The Fair-Value Fight
Fair-value pricing resulted in a pro-cyclical progression of writedowns that

bore no relation to actual value during the subprime crisis. Those writedowns
were at the center of the crisis. Critics of fair-value accounting charged that,
because liquidity in subprime investments had dried up as the subprime crisis

grew, the only prices available for “fair-value” accounting were distress prices
from desperate sellers. They asserted that those prices in no way reflected the
actual value of the higher-rated subprime instruments as measured by their
cash flows or defaults. They appear to have a point.
As Fed chairman Bernanke testified before Congress on September 24, 2008,
when he was seeking authority to purchase distressed bank assets, CDOs had
two values: the price available in a quick sale in an illiquid market, and a much
higher value if it is held to maturity. He noted that a vicious circle was being
created by fair-value accounting, which required a markdown to the fire-sale
price, which caused additional sales, which caused further markdowns and so
on. Bernanke, nevertheless, rejected the suspension of fair-value accounting,
on the grounds of shareholder protection and full disclosure even though their
stock was being decimated by such accounting. At the same time, Bernanke
wanted $700 billion from TARP to buy distressed securities at their hold-to-
maturity (discounted cash flow) value. This raised a question in the press: If
hold-to-maturity was good enough for taxpayers, why not for investors? In
any event, that asset purchase plan was abandoned in favor of direct capital
injections into financial institutions holding these securities.
Simple math seems to suggest that many of the enormous writedowns on
privately issued subprime mortgage-backed securities were unnecessary. Most
of the massive writedowns on the Super Senior subprime securities had been
taken by the end of 2008. At that time, some 16 percent of subprime loans
were delinquent by more than sixty days. This meant that 84 percent of those
mortgages were still performing. There is also the issue of credit protection.
The Super Senior tranches of CDOs were protected from defaults by the lower
tranches. But the Super Senior subprime securities were at the center of the
crisis at most large banks and at AIG, which was weakened after it wrote off
some $20 billion in Super Senior credit-default swaps (CDSs). AIG noted that
these were marked-to-market unrealized losses due to fair-value accounting
and that it did not expect to have an actual material loss from its Super Se-
nior exposures. Fifty percent of UBS’s $18.7 billion in write-offs from U.S.
mortgage exposure was due to Super Seniors. Merrill Lynch’s U.S. CDO
subprime net exposure consisted primarily of its Super Senior CDO portfo-
lio. On September 30, 2007, Citigroup had $55 billion in subprime exposure,
$43 billion of which was due to exposures in Super Seniors. Of Citigroup’s
$14.3 billion pretax loss (net of hedges) in 2008 from subprime-related direct
exposure, $12 billion was attributable to net exposures to the Super Senior
tranches of CDOs and derivatives on asset-backed securities, most of which
related to Super Seniors.
Subprime mortgages defaulted at a rate of about 4 to 5 percent in the years
immediately preceding the subprime crisis, so the CDOs were modeled and
overcollateralized to expect that loss amount. This would mean that the Super
Seniors were exposed to only 12 percent of the 16 percent of delinquencies
at the end of 2008. Moreover, the Super Seniors received default protection

from lower classes in the CDOs. The Super Senior tranches also generally had
additional credit protection from CDS, or monoline insurance (which proved
nearly nonexistent). That protection often totaled about 5 percent of the face
value of the Super Senior. If available, such protection would offer further
protection to the Super Seniors.
Moreover, the 16 percent delinquency rate must be adjusted for the fore-
closure value of the residences securing the subprime mortgage. The S&P
Case-Shiller U.S. National Home Index indicated an 18.2 percent decline in
housing prices in the United States in 2008. Assuming an even steeper decline
in subprime-related homes, say 50 percent, the sale of the foreclosed houses
would cut foreclosure losses in half. With credit protection, the Super Seniors
faced an even smaller loss.
In addition, at least some of the subprime loans would be refinanced, even
if on modified terms, as interest rates dropped. These refinancings would fur-
ther reduce exposure of the Super Seniors. So, even with a really sharp risk
discount, it would be very hard to value these subprime mortgages based on
their expected cash flows at values of only a small percentage of their face
amount. Yet fair-value writedowns on subprime CDOs were often 50 percent
or more. Indeed, Merrill Lynch sold some $30 billion of its subprime holdings
for twenty-two cents on the dollar.
Fair-value accounting thus appears to be anything but fair. One accountant
complained to the FASB with respect to its fair-value accounting requirement:
“May the souls of those who developed FASB 157 burn in the seventh circle
of Dante’s Hell.”30 Warren Buffett likened mark-to-market requirements for
measuring bank regulatory capital to throwing “gasoline on the fire in terms
of financial institutions.”31 Former Fed chairman Paul Volcker was another
opponent of fair-value accounting for banks.
As one author noted:
The argument against fair value is a compelling one: volatile markets make securi-
ties valuation difficult and undermine investors’ confidence, forcing companies to
mark down values, leading to greater illiquidity and further markdowns. The more
the markdowns impair capital, the greater the loss of investor confidence, and the
faster the churn of the self-reinforcing cycle.32
Other critics claimed that because the writedowns were excessive, they
would give a boost to the company’s earnings in future periods when the
markets resumed normal operation, at which time those instruments would
be revalued upward to reflect their actual value. In other words, they would
shed their panic discount. There seemed to be some indication that this was
the case as the market recovered.
A study published in August 2008 questioned the accuracy of the indexes
used by many banks to value their subprime securities and, thereby, to assess
their losses. The lack of a market for those securities made such indexes unreli-
able. Sixty-five members of Congress requested that the SEC suspend mark-

to-market accounting, asserting that it was exacerbating the subprime crisis

and limiting banks’ ability to make loans. However, some activist shareholder
rights groups opposed that request. The Consumer Federation of America and
three other trade groups representing consumer interests petitioned the Trea-
sury Department not to abandon fair-value accounting in its efforts to shore
up faltering financial services firms.
Lloyd Blankfein, the CEO of Goldman Sachs, was also a supporter of fair-
value accounting. He believed, and publicly stated, that companies suffering
from subprime writedowns had not accurately valued the instruments in their
portfolios. Blankfein boasted that Goldman Sachs’ practice of daily marking
of positions to market allowed it to avoid the worst of the subprime losses
because that practice led the firm to recognize the risk in those instruments
and caused it to sell off or hedge those positions before the crisis arose. He
believed that if mark-to-market accounting had been more aggressive at other
firms, there would have been an early warning of the subprime crisis.
Blankfein and his predecessor as Goldman CEO, Treasury Secretary Paul-
son, were in close contact throughout the subprime crisis. It is unclear how his
views might have swayed Paulson, who was accused of acting inappropriately
by staying too close to Blankfein during the crisis. For whatever reason, the
Treasury Department refused to recognize the pernicious effects of fair-value
accounting. It was not until the subprime crisis peaked in September 2008
that Paulson expressed the view that financial institutions should be allowed
to treat their subprime assets as held-to-maturity, which would allow them to
be valued at their amortized cost, rather than at distress prices.
The American Bankers Association, the U.S. Chamber of Commerce, and
Republicans in Congress called for legislation to suspend fair-value accounting
during the subprime crisis, but Senator Chris Dodd (D-CT), chairman of the
Senate Banking Committee, defended the requirement and blocked legislative
relief. He had been one of the strongest advocates in Congress for expanding
subprime lending and now exacerbated the crisis that lending caused. However,
the FASB was pushed by other members of Congress to relieve the banks of
this requirement. On September 30, 2008, the SEC proposed a temporary sus-
pension of mark-to-market accounting. That suspension would have allowed
financial institutions to value instruments based on their discounted cash flows,
rather than by market valuations, which often were nonexistent in the panicked
subprime mortgage markets. The European Union announced the adoption of
the same approach. This effort was aided by Moody’s and Standard & Poor’s,
which agreed to assess not only the probability of a loss but also the likely
size of the loss. Unfortunately, that action came only after huge writedowns
had been taken that were based only on rating downgrades (down to less than
junk bond status)—themselves based solely on the likelihood of a loss, without
regard to the size of the loss.
Insurance companies treated their impaired mortgage-backed securities as
only “temporarily impaired.” This meant that in measuring their regulatory

capital they did not have to include them as losses until it was determined
that the losses were not temporary. However, such treatment raised alarms.
MetLife had classified $27 billion in securities in that category, and concern
arose that the company might face a huge loss in the future. Some large in-
surance companies, including MetLife, Prudential, and New York Life, were
in talks with the government at the end of October 2008 over injecting funds
into their operations through the sale of equity stakes.
The FASB Reacts
The Emergency Economic Stabilization Act passed on October 3, 2008, re-

quired the SEC to conduct a study of mark-to-market accounting. This caused
the agency to change its position. On December 5, 2008, the SEC announced
that it had decided not to suspend mark-to-market accounting. In the SEC report
required by Congress, the agency asserted that mark-to-market accounting
should not be eliminated or suspended, but it did suggest some improvements.
The SEC report stated that it found no evidence that fair-value accounting had
played any significant role in the collapse of financial institutions; rather, it
blamed their liquidity problems on bank runs. That conclusion seemed at odds
with the facts as massive writedowns were taken based on fire-sale prices, not
the inherent value of actual cash flows and default rates.
In the meantime, on October 10, 2008, the FASB issued fast-track guidance
on how to fair-value assets that did not have an active market, such as subprime
securities. That guidance was mostly gobbledygook. Under pressure from the
European Union, the International Accounting Standards Board (IASB) agreed
to allow European firms to change their accounting treatment of troubled
assets. Relenting to pressure from the troubled financial services firms, the
FASB announced on December 22, 2008, that it would make a change in its
mark-to-market rules to provide some limited relief. The agency announced in
January 2009 that it would allow firms to use methods other than “fair value”
for certain subprime securitizations that were viewed as temporarily impaired
in price. This, of course, raised the question of whether subprime instruments
were impaired temporarily or permanently. The FASB issued a document
providing guidance and relief to the banks on April 2, 2009. The text in it was
carefully couched in ambiguity but was thought to provide financial institutions
with more flexibility, allowing them to treat the subprime securities as held
for investment. The guidance, which went into effect in the second quarter of
2009, was expected to boost the earnings of firms with subprime exposures
when those financial institutions valued their assets at more realistic prices.
The change certainly gave a boost to the stock market.
The IASB agreed with the FASB, on March 24, 2009, that the two bodies
should work together to achieve common standards. That agreement lasted
less than two weeks. The IASB refused to follow the FASB’s interpretative
guidance on fair-value accounting issued on April 2, 2009. Instead, the IASB

announced a six-month study of the issue. The Group of Twenty, at their meet-
ing in London that same day, also called on the FASB and the IASB to further
address fair-value accounting issues and provide more clarity and consistency.
The result of all of this debate was confusion and uncertainty, the very thing
accounting standards were supposed to prevent.
The FASB’s actions also raised a storm of controversy. Critics claimed that
it allowed institutions to cover up losses. A front-page Wall Street Journal
article reported that financial services firms had spent $27.6 million lobbying
Congress to pressure the FASB to grant that relief.33 A subsequent report by
the Financial Crisis Advisory Group was critical of the pressure placed on the
FASB by politicians with respect to their fair-value guidance. Nevertheless,
that relief allowed banks to keep assets on their books at higher, more realistic
values, and it did appear to ease the crisis.
The Bank for International Settlements’ (BIS) Basel Committee on Bank-
ing Supervision published proposed guidance for banks in November 2008 on
how they should value financial instruments held in inventory. Its concern was
that banks were using overly optimistic pricing models for instruments that
did not have an ascertainable market price. The BIS also wanted independent
verification of prices. Actually, it later appeared that the banks had become
too pessimistic in their valuations during the subprime crisis, valuing their
subprime investment at prices lower than would be justified by a discounted
cash flow analysis. The Basel guidance was adopted as proposed on April 15,
2009.
The FASB remained conflicted over fair-value requirements. It announced
in August 2009 that it was considering expanding mark-to-market require-
ments to loans and all other financial instruments. It renewed that threat in
May 2010 but met stiff resistance from the banks because of the serious effect
such accounting could have on their balance sheets. This, of course, would
only add further volatility to bank balance sheets and would surely lead to
their complete destruction in the next financial crisis. The European Union
was also inconsistent, announcing a delay in implementation of fair-value
requirements that would have required large writedowns on assets of financial
services firms in November 2009.
Real Estate Appraisals
The answer to the debate over how to value CDOs holding subprime mortgages
appears to be a simple one. At the bottom, the CDO is simply the sum of the
values of the residences underlying the mortgages in the securitized pool. A
real estate appraiser seeks to determine the “market value” of the property,
the same goal of fair-value accounting when it marks-to-market. Residential
real estate appraisers define market value as: “The most probable price which
a property should bring in a competitive and open market under all conditions
requisite to a fair sale, buyer and seller each acting prudently, knowledge-

ably and, assuming the price is not affected by undue stimulus.”34 The 1936
Underwriting Manual prepared for the Federal Housing Administration by
Frederick Babson sets forth the ground rules for determining the market value
of residential property. They are:
1. Valuation presupposes the existence of a buyer.

2. Valuation presupposes the existence of a seller.
3. Valuation presupposes a sale in which the buyer is well-informed, and
acts intelligently, voluntarily, and without necessity.
4. Valuation presupposes a sale in which the seller is well-informed, and
acts intelligently, voluntarily, and without necessity.
5. Valuation endeavors to estimate prices which are fair and warranted,
that is, prices which represent the worth at the time of appraisal of
the future benefits which will arise from ownership, rather than prices
which can be obtained in the market.
6. Valuation recognizes the importance and usefulness of sales prices,
provided it is determined whether or not such sales prices were fair
and warranted; and provided the motives, intelligence, and wisdom of
the parties to the sales, as well as other conditions surrounding them
and influencing the determination of the sales prices, are ascertained
and weighed.
7. Valuation presupposes and recognizes that intelligent buyers and sell-
ers consider the utility of real property.
8. Valuation recognizes that replacement cost at the time of appraisal
sets one approximate upper limit of possible value.
9. Valuation recognizes that value may be less than replacement cost.
10. Valuation recognizes that the prices at which competing properties are
available for purchase set or tend to set the approximate upper limit
of possible value.
11. Valuation presupposes and recognizes that well-informed buyers and
sellers are commonly aware of the existence of competing properties
and compare their respective asking prices, desirability, advantages,
and disadvantages, and future prospects.
12. Valuation presupposes and recognizes that well-informed buyers and
sellers compare and contrast the advantages and disadvantages of
renting with those involving ownership.35
Many of these elements were missing for subprime CDOs during the crisis.
Comparable sales were scarce during the subprime crisis because most sales
were made at distress prices under pressure and not “voluntarily and without
necessity.” Typically, a residential real estate appraiser will compare the prop-
erty being valued with properties recently sold in the same local area that have
similar characteristics. Adjustments are then made to the value of the subject
property to reflect differences between it and the one it is compared with, for

example, deducting an amount to reflect its having fewer bathrooms. That

classic valuation method was not available during the subprime crisis.
In the absence of the ability to compare like properties in the distressed
subprime market, real estate appraisers use a reconstructed-value approach
that seeks to establish value based on the cost of reconstructing the subject
residence. The Marshall & Swift Residential Cost Handbook provides these
costs and adjusts them by locale and quality of construction. However, the
reconstructed-cost methodology is not favored because the market might not
want to value the property at its reconstructed cost, particularly under distress
conditions, such as those present during the subprime crisis. Reconstructed
cost, therefore, is generally used only as a measure of the maximum value of
the house.
Appraisal of Income-Producing Property
There is an alternative appraisal method available when the property generates

income. Real estate appraisers value the property based on its expected income
stream, as in the case of a rental property. Here, the property (the CDO) is
income-producing because the underlying mortgages will produce an expected
stream of income. The appraiser must make allowances for expected defaults,
but then extrapolates the present value of the CDO based on its expected in-
come stream. Supporting this methodology are the appraisal methods used to
value the stock of corporations.
Traditionally, corporate appraisal proceedings followed the “Delaware
Block” approach, employed by the Delaware courts, where many important
appraisal proceedings occur. Under the Delaware Block approach, appraisers
determine the “fair value”36 of stock in the subject corporation by using three
different methodologies: market value, net asset value, and earnings value.37
The Delaware court then assigns various weights to each methodology, depend-
ing on the nature of the property. The price at which the stock of the company
being appraised is widely traded will be the price assigned to the appraisal,
because that is the best determination of value. However, if the stock is illiquid,
that methodology is given less weight, and the court might assign more weight
to the net asset value or earnings value of the company.
Net asset value is not completely useful because this is the liquidation value
of the company, but the company is not being liquidated. Its value as an ongoing
concern might better be measured by its income production. Delaware had, for
years, used an earnings value appraisal method that relied on a capitalization
chart prepared by Professor A.S. Dewing, but that chart became outdated, and
more modern methods of determining earnings value were developed, including
the discounted cash flow method. The Delaware Supreme Court abandoned
its rigid block approach in 1983 and allowed the use of discounted cash flow
and other recognized valuation methods.38
If balance sheet accounting based on the fair value of CDOs is thought to

be necessary, basic valuation principles would require that cash flow or other
valuation methods be used to provide the best measure of the value of the
instrument when the residential mortgage market is not functioning. When a
market is disrupted or frozen, as in the case of subprime CDOs, alternative
valuations should be used, or the fair-value requirement should simply be
suspended until the market recovers.
Risk Models
Risk modeling took on new importance in financial markets with the creation
of the Black-Scholes options pricing model in 1973. That pricing formula gave
rise to a widespread belief that the risks from complex financial instruments
could be scientifically predicted with a degree of certainty. Also in widespread
use were “value at risk” (VaR) models, which financial institutions used to
assess the risks presented by their portfolios and proprietary trading. Those
models even became the basis for capital requirements in Basel II for banks
worldwide. The VaR models looked to historical prices over a given period to
determine the expected rate of price changes in the instrument. The results were
back-tested to ensure that their predictive ability was accurate. Portfolios could
also be stress-tested by using amounts larger than those predicted by the VaR
model as a means of assessing risks from unexpected market movements.
A risk model developed by David Li, the Gaussian Copula correlation model,
did for CDOs what the Black-Scholes model did for options. It allowed what
appeared to be a precise mathematical computation of the likely risks posed
by these instruments. Subprime CDOs were often structured with tranches
that had varying risk levels, which were designed to appeal to investors with
different risk appetites. The top tranche—the “Super Senior”—was often
given a triple-A or AA credit rating, even when backed by subprime debt. In
order to assign a rating to the varying CDO tranches, the credit rating agen-
cies employed statistical models that sought to determine the probability of
defaults on the underlying mortgages. If a senior tranche was protected from
that expected default rate by the lower tranches, or by other means, such as
credit insurance, it would be given a high rating.
The Gaussian Copula risk models failed to predict the massive losses
sustained by commercial banks in the United States and Europe from their
exposures to these subprime instruments. However, there was no cabal us-
ing a secret formula to deceive investors. Moody’s actually posted its model
(CDOROM), which became the industry standard, on the Internet in 2004. The
whole world was free to discover its flaws but, except for a few naysayers, the
model went largely unchallenged. Interestingly, the New York Times accused
the rating agencies of being too transparent because the issuers of CDOs were
able to structure their offerings to accord with the model and obtain high credit
ratings. These issuers were also accused elsewhere of gaming the ratings
methodology by including loans with both high and low FICO credit scores

in order to meet the average score required by the rating agency for a highly
rated offering. The inclusion of the lower scores, rather than those closer to
the required average, assured a greater number of defaults.
Another rating agency, Fitch, used a Monte Carlo multistep simulation default
probability model to stress-test the CDOs that it was rating, a technique that seeks
to look at a range of possible outcomes and their probability of occurrence. This
too failed to reckon with declining credit standards and punitive interest rate
increases. These risk models were created by the so-called “quants” who used
quantitative analysis including complex mathematical formulas, which are little
understood, except by the cognoscenti. They were treated as science since they
were developed by the high-IQ quants, but as Warren Buffett warned, “beware
of Geeks . . . bearing models.”39 The mathematical model used to rate CDOs
proved badly flawed.40 Critics charged that these models were defective because
they relied on historical prices generated by a rising market. That Pollyannist
approach overlooked the possibility of a hundred-year “perfect” storm, which
arrived in the form of the subprime crisis. These unusual events were given other
names, such as “fat tails” and “outliers.” They were also called “black swans,”
as a metaphor for the widely held belief that there was no such thing as a black
swan, until explorers reached Australia and found just such a bird.
The dangers posed by these outliers were well known and were even the
subject of a book written by Nassim Nicholas Taleb, titled The Black Swan. He
described the hazards of events that have a low probability and a large impact.
He argued that risk managers were reckless in using risk assessment measures
that exclude the possibility of such events. Some critics asserted that these
risk models were like having safety airbags in an automobile that worked just
fine until there was a wreck. As the world learned from the subprime crisis,
a Hurricane Katrina does strike on occasion.41 However, the model builders
had to contend with the fact that, although occasional and temporary regional
downturns occurred, the housing market had not experienced a nationwide
slump since the Great Depression.
Regulatory Reform
Financial Literacy of Regulators
A remarkable fact flowing from the subprime crisis was that financial regula-
tors did not have a clue as to the dangers presented by subprime mortgages
or the flaws in their modeling or the effects of mark-to-market accounting in
a market panic. Bank regulators and the administrations of Bill Clinton and
George W. Bush blindly forced massive subprime originations and investments,
without any reflections on the dangers of such lending, and they were caught
flat-footed when the subprime crisis arose. The SEC, in particular, seemed
out of touch with the market that it regulated and the business activities of
its registrants.

Despite the past claims of the superiority of SEC regulation, the largest
investment banks under its supervision failed. The agency was helpless
during the crisis. It could only lash out blindly by attacking naked short
sales, which probably did not need attacking, and seeking more regulatory
authority in areas that did not need regulating. Most embarrassing, Bernie
Madoff carried out the world’s largest-ever fraud right under the SEC’s
nose, and the agency, despite numerous clues, lent him legitimacy by having
him register as an investment adviser and even had him serve on an agency
advisory committee. In a prison interview, Madoff expressed disdain for
the incompetency of the SEC examiners and was amazed that they had not
caught him years earlier.
SEC chairman Cox seemed to be missing in action as well as clueless as
Bear Stearns, Merrill Lynch, and Lehman Brothers failed. He had publicly
stated three days before Bear Stearns fell that the large investment banking
firms regulated by the SEC, including Bear Stearns, had satisfactory finan-
cial cushions. Cox was also reported to be absent during critical phone calls,
attended a birthday party as Bear Stearns’ rescue was being negotiated, and
refused to interrupt a previously planned vacation in the Caribbean after Bear
Stearns failed. The SEC was the assigned regulator of Bear Stearns, but it was
only a bystander when Bear’s rescue was arranged by the Treasury Depart-
ment and the Fed.
These regulatory failures indicated that the SEC did not have the requisite
expertise and financial sophistication to deal with complex financial markets.
Such failings derive, in large measure, from the fact that the agency views
itself primarily as a law enforcement agency and only secondarily as a financial
regulator. As a law enforcement agency, it has proved a failure, as demonstrated
by the Madoff case and the fact that it learned about the Enron-era account-
ing scandals from newspaper accounts. Spitzer may have been excessive in
his attacks on financial services firms, but the SEC’s impotency opened the
door for him.
If financial service regulators are going to regulate, they should at least
take time to learn the business and follow developments. Historically, most
job training at the SEC is “on the job.” Such training, while valuable to the
individual, results in a narrow set of skills. This “stovepipe” mentality develops
expertise in only one narrow area for staff members and that is often parochial
to not only the SEC but also a particular division in that agency. New employ-
ees at the SEC are typically very bright, newly minted lawyers, accountants,
investigators, and auditors, or sometimes more seasoned individuals, but with
very limited knowledge of the full spectrum of financial services and markets.
The SEC is also marked by a revolving door for its employees who typically
serve only a few years and then move to the private sector, which results in
another serious drain in expertise.
The performance of SEC entry-level employees and lateral hires is almost
always excellent in the matters to which they are assigned. However, as a prac-

tical matter, they have no ability to do anything other than carry out particular
tasks assigned to them. They do not have the wherewithal to uncover and pursue
issues affecting financial services and markets overall. With notable exceptions,
even the most experienced staff members lack broad-based knowledge.
Today, financial services are completely intertwined. A banking regulator
must know the securities and derivatives business, and how it is regulated,
because the financial holding companies that they regulate have financial
subsidiaries that are broker dealers, futures commission merchants, and OTC
derivatives dealers. The SEC must know the banking business, and how it is
regulated, because many of its large broker-dealers are part of a bank holding
company structure. The SEC must know the derivatives business, particularly
if it is to jointly regulate OTC derivatives with the CFTC. Federal financial
service regulators must know the insurance business and its limitations, par-
ticularly credit insurance.
In order to become more effective, the SEC must also become more of a
financial services regulator and less of a law enforcement agency. The agency
tries to cover its regulatory shortcomings with high-profile enforcement ac-
tions that are almost always settled by the respondent without admitting or
denying any violations. This process has become the equivalent of a tax on
public companies and registrants. The tax must be paid or the firm will lose its
franchise. The SEC’s action against Goldman Sachs that is described below
is a case in point. That case should never have been brought, but Goldman
Sachs paid $550 million to settle it in order to protect its franchise from further
adverse publicity and SEC attacks. In many instances, innocent shareholders
end up paying the fines associated with such actions. The fine in the Goldman
Sachs case, for example, came from the corporate treasury.
The SEC enforcement actions accomplish little. The agency has been on an
almost fifty-year crusade to stop insider trading, with a notable lack of success,
but those cases generate a lot of publicity. Yet, SEC actions have proved no
deterrent to insider trading. It is rare to see a merger that is not accompanied
by insider trading, and reports surface almost daily in the press of further
insider trading cases. One of the most spectacular reports was issued October
16, 2009, when six individuals were arrested and charged with participating
in a giant inside-trading ring. The leader of the ring was a billionaire hedge
fund manager for the Galleon Group named Raj Rajaratnam. Other members
of his ring were executives at IBM, the consulting firm McKinsey, and Intel.
It was reported in the press that the SEC and Justice Department had failed
to pursue Galleon in a case brought in 2000 that involved inside information
passed to the firm by Roomy Kahn, who had informed for the government
regarding the charges brought against Galleon and Rajaratnam in 2009.
A new approach is needed. An effective financial services regulator does
not always act as an adversary to business. The idea of financial services
regulation is to ensure its continued and effective development. Yale econo-
mist Robert Shiller has suggested that financial regulators “must hire enough

qualified staff to understand the complexity of the innovative process and

talk to innovators with less of a disapprove-by-the-rules stance and more that
of a contributor to a complex creative process.”42 That philosophy should be
incorporated into the SEC.
Functional Regulation
The United Sates operates under a “functional” regulatory system in which dif-
ferent regulators regulate particular financial services. Since many large banks
are engaged in multiple financial services activities, they have multiple regula-
tors, none of whom coordinate with each other in any meaningful way. This has
resulted in overlap and regulatory conflict and inefficiency. Under functional
regulation, financial services firms are regulated at the state level by fifty state
insurance commissioners, state securities commissioners in fifty states and the
District of Columbia, fifty state bank regulators and fifty state attorneys general.
Federal functional regulators include the Fed, the Office of the Comptroller of
the Currency (OCC) in the Treasury Department, the Federal Deposit Insurance
Corporation (FDIC), the SEC, the Commodity Futures Trading Commission
(CFTC), the Federal Trade Commission (FTC) and self-regulatory bodies such
as the Financial Industry Regulatory Authority (FINRA) and the National Fu-
tures Association (NFA). The Justice Department has also become a financial
services regulator and a new Consumer Financial Protection Bureau was created
in 2010 with broad jurisdiction over many financial services.
Treasury Report
Treasury Secretary Henry Paulson warned in 2006 that the country was “cre-
ating a thicket of regulation that impedes competitiveness.”43 The Treasury
Department thereafter conducted a study of the existing regulatory structure
and it published its report in March 2008 (Treasury Blueprint).44 The Treasury
Blueprint concluded that functional regulation was ineffective and was un-
dermining America’s leading role in global financial services. The Blueprint
also concluded that functional regulation “exhibit[ed] several inadequacies,
the most significant being the fact that no single regulator possesses all of the
information and authority necessary to monitor systemic risk, or the potential
that events associated with financial institutions may trigger broad dislocation
or a series of defaults that affect the financial system so significantly that the
real economy is adversely affected.”45
The Treasury Blueprint recommended that the United States adopt a “Twin
Peaks” approach to regulation, a system that is currently used in Australia and
the Netherlands. The Treasury Blueprint actually took a “Three Peaks” ap-
proach that would have three separate bodies implementing three specific regu-
latory goals: (1) market stability regulation, (2) prudential financial regulation,
and (3) business conduct regulation. This objectives-based approach would

require a consolidation and reshuffling of the existing functional regulators

in the United States into essentially three principal regulators. The subprime
crisis derailed that effort.
Subprime Crisis Regulation Proposals
Even while the Treasury study was proceeding to prepare the Blueprint in
March 2008, a sea change was occurring as the subprime crisis flared and grew
in intensity. Only a few days before publication of the Treasury Blueprint, the
Wall Street Journal declared in a front-page article on March 24, 2008, that
a new era of increased regulation could be expected due to problems in the
subprime market.46 The subprime crisis did indeed touch off a wave of popu-
lism that demanded more, not less, regulation. The presidential campaign of
2008 was fought and largely won over the concerns that regulation had been
relaxed too much, and the functional regulators used that political concern as
the argument for expanding their jurisdiction and for the most part avoided
consolidation.
Emerging from the disgrace of being forced to resign as governor of New
York, Eliot Spitzer published an op-ed piece in the Washington Post on No-
vember 16, 2008, in which he claimed that the subprime crisis had proved
that he was right in his campaign against Wall Street as New York attorney
general and in his efforts to stop the deregulation of financial markets. Spitzer
argued that more regulation was needed because “unregulated competition
drives corporate behavior and risk-taking to unacceptable levels.” He regret-
ted the fact that “mistakes” in his “private life” prevented him from assisting
the incoming Obama administration in ushering in a new era of Franklin
Roosevelt–style regulations.47
Apparently President Obama did not need Spitzer’s aid in creating new
regulations. The new treasury secretary, Tim Geithner, took an active approach
when he announced the Obama administration’s new financial regulatory
proposals in June 2009.48 Geithner asserted that the entire financial regulatory
structure in the United States had to be revised because the existing system was
a confused set of complex rules that created perverse incentives and regulatory
competition, while leaving broad gaps in coverage. Geithner sought legislation
to give the Fed oversight authority over all financial institutions that posed
systemic risk if they failed. This would make the Fed the ultimate manager
of those firms. As demonstrated by its strong-arm treatment of management
at Bank of America and Citigroup, the Fed will not shy away from being an
active manager, but in a time of crisis it is easy to forget that governments are
institutionally incapable of running a business.
The Treasury Department refined its proposals on July 23, 2009. It then
sought the creation of a new national bank supervisor, and it wanted to establish
a resolution program for failed financial institutions that would involve the
participation of both the FDIC and the SEC. The federal government would be

given standby authority to bail out failing banks by providing loans, injecting
capital, or assuming liabilities, plans that would have to be approved by the
Fed and the Treasury Department (after consulting with the president), as well
as the FDIC or the SEC, depending on the type of institution. The International
Monetary Fund later proposed a similar program for European banks.
The administration also asked for the elimination of the Office of Thrift
Supervision, which would be folded into the OCC. The federal thrift and
thrift holding company charters would be eliminated. That action was taken
in response to the effort by AIG to avoid more stringent regulation by reor-
ganizing into a thrift holding company. Bank examination fees would also be
harmonized, with bank fees based on the bank’s size and financial condition.
Smaller banks, those with less than $10 billion in assets, would not have to
pay systemic based examination fees.
Turf Wars
The Fed was initially chosen by the Obama administration as the central
systemic regulator, a role that would give it the power to designate financial
institutions that were too big to fail. These institutions would be subjected to
higher capital requirements. However, the recommendation to make the Fed the
systemic regulator met resistance from some members of Congress and other
regulators. FDIC chair Sheila Bair was seeking to create a financial stability
oversight council that would be a superregulator with oversight of all financial
regulators. However, the administration’s proposal for a regulatory council
envisioned it only as a working group, and Bernanke urged Congress not to
expand its powers beyond consultation. As will be seen, Congress followed
the Bair approach to some degree.
The Geithner proposal also created some regulatory conflicts over juris-
diction among the OCC, the SEC, and the FDIC. Those agencies found their
power threatened, and they were critical of giving too much power to the Fed.
Geithner became frustrated at a meeting with those regulators, including the
heads of the SEC, the FDIC, the CFTC, and the Fed, and berated them for
their intransigence on his proposal. That did not help matters, and the ad-
ministration’s regulatory reform proposals started to bog down in Congress
as lobbying intensified and the interested agencies continued to battle over
turf. Robert Zoellick, president of the World Bank, also opposed the Geithner
proposal, saying that authority over systemically important financial institu-
tions should be given to the Treasury, instead, because it is more accountable
to Congress. It was unclear why the president of the World Bank had any role
to play in such a decision.
President Obama tried to move his reforms forward with a speech on Wall
Street on September 14, 2009, in which he criticized the banks receiving bail-
outs before an audience of financial leaders. He stated that “we will not go back
to the days of reckless behavior and unchecked excess that was at the heart of

the crisis, where too many were motivated only by the appetite for quick kills
and bloated bonuses.”49 That blast was followed by a Fed proposal that would
allow it to block compensation schemes that it believed would encourage undue
risk-taking. Senator Chris Dodd, chairman of the Senate Banking Committee,
responded to this infighting in September 2009 with a legislative proposal to
merge the four federal bank regulators (the Fed, the OCC, the FDIC, and the
Office of Thrift Supervision [OTS]) into one banking superregulator.
The Obama administration began shifting its position as opposition to its
proposals mounted. Its reforms evolved into basically leaving the financial
regulatory structure as is, with the exception of merging the OTS with the
OCC. The OTS opposed that proposal, but was eventually eliminated. The
Obama administration also wanted a systemic risk oversight group, a council
of regulators that would be led by the Fed, but other regulators fought that
proposal because they thought that it still gave the Fed too much power.
Another fight broke out over the so-called “Volcker rule,” named after
former Fed chairman Paul Volcker, who wanted a return to the days of the
Glass-Steagall Act when commercial banking activities were separated from
investment banks that conducted underwriting and other securities. That rec-
ommendation met opposition from Fed chairman Ben Bernanke and others.
President Obama went on another populist attack against Wall Street in
January 2010. He first announced plans for a tax on the large banks that would
pay for TARP. He then flew to Boston in support of a Senate race for the seat
left open by Ted Kennedy’s death, where he bashed the banks. A Republican
won the seat. That loss enraged the president, and he announced his plan to
support the Volcker rule two days later. A preliminary report by the European
Union rejected the Volcker proposal as being inconsistent with its risk man-
agement principles.
The SEC and the Goldman Sachs Case
The SEC was the consolidated supervised entity (CSE) regulator for Lehman
Brothers, but was caught flat-footed by the liquidity crisis at Lehman Broth-
ers, even though SEC staff members had taken up residence at the firm to
monitor its finances after Bear Stearns failed. More embarrassment over the
Lehman failure followed when it was disclosed that Merrill Lynch executives
had advised the SEC that Lehman was overstating its liquidity after the close
of its first quarter in 2008. Merrill Lynch was concerned because its more
conservative approach made it appear to be less liquid than Lehman, caus-
ing concerns among Merrill Lynch counterparties. The Fed also had staff on
premises at Lehman during the crisis, and it too was warned by Merrill Lynch
of the liquidity issue. Unlike the SEC, the Fed kept close watch, along with
Treasury, on Lehman’s declining liquidity and sought to pressure that firm to
raise more capital before it failed.
The new SEC chair, Mary Schapiro, who was appointed by President

Obama, admitted in congressional testimony that the CSE program was inad-
equately staffed, stovepiped in sharing information, and insular. She further
testified that CSE supervision required a bank regulator approach rather than
the law enforcement, full disclosure approach of the SEC. Schapiro admit-
ted that the SEC was ill-suited to act as a prudential regulator. She was also
concerned that the agency’s many shortcomings might cause Congress to turn
its lights off. To survive, the SEC went on a campaign against Wall Street,
seeking other areas to regulate such as high frequency flash trading, corporate
governance and executive pay. The agency set up a new division to control
investment and business risk (something it had relied on the market to do in
years past). It adopted political correctness as policy, requiring, among other
things that public companies warn their investors of the risks that global
warming might pose to their businesses, a matter that not even climatologists
could agree upon.
The agency also attempted to burnish its image and attract headlines by
following Eliot Spitzer’s approach in bringing high-profile prosecutions
against major industry players. Goldman Sachs became one such target. The
sensational charges levied by the SEC against Goldman on April 16, 2010,
for its sale of a synthetic collateralized debt obligation (CDO) involving some
credit-default swaps (CDSs) to a German bank made headlines worldwide
and caused a 125 point drop in the Dow Jones Industrial Average. The Justice
Department then announced that it was conducting a criminal investigation
of the SEC charges. The actions against Goldman cut the value of its stock
by 20 percent.
At the time this case was filed, the SEC and the Obama administration were
seeking broader regulatory jurisdiction from Congress over credit-default
swaps. Perhaps not coincidentally, the president announced on April 17, 2010,
that he would veto financial services legislation if it did not regulate the over-
the-counter derivatives business. This turned the case into a political football.
Gordon Brown, the British prime minister, who was in a tight political race,
charged that the case established the moral bankruptcy of Goldman Sachs, but
he still lost the election. President Obama was, however, able to pass financial
services reform legislation a few months later that contained provisions that
extensively regulated derivatives. A provision was also added to that legisla-
tion to cover the SEC’s case against Goldman Sachs.
SEC Chair Mary Schapiro was featured on the cover of Time magazine
after the filing of the Goldman Sachs case. She, along with Sheila Bair, the
FDIC head, and Elizabeth Warren, the advocate for the new financial services
consumer protection agency, were dubbed the “New Sheriffs of Wall Street”
by the magazine. That attention might beget bad fortune. That title had been
bestowed by the television program 60 Minutes on the since disgraced Eliot
Spitzer, also selected as “Crusader of the Year” by Time. This attention further
harkened back to the famous Time cover of the “The Committee to Save the
World” featuring Alan Greenspan, Robert Rubin, and Larry Summers for their

work during the Asian Flu financial crisis. Ironically, all three later suffered
setbacks. Greenspan and Rubin were harshly attacked for their role in the sub-
prime crisis, and Summers was forced out of his role as president of Harvard
University for some politically incorrect remarks and was able to gain only a
modest role in the Obama administration before resigning in 2010.
The SEC continued its stepped-up enforcement activities by launching
a broad-scale investigation of CDOs issued by Morgan Stanley, JPMor-
gan, Citigroup, Deutsche Bank, and UBS, as well as Goldman Sachs. The
Financial Crisis Inquiry Commission, appointed by Congress to determine
the causes of the subprime crisis, also accused Goldman Sachs of dragging
its feet in responding to document requests and claimed that when produc-
tion was finally made it was so massive as to be useless. Goldman Sachs
executives were pilloried before the Senate Finance Committee over the
transaction at issue in the SEC’s case and over a CDO transaction called
Timberwolf. An internal Goldman Sachs email was displayed at the hearing,
which stated that one potential investor for Timberwolf was too smart to buy
such “junk.” Following that hearing, the SEC commenced an investigation
of that transaction. An investor in Timberwolf also brought a fraud action
against Goldman Sachs, seeking $56 million in actual damages and punitive
damages of $1 billion.
The Justice Department then launched an investigation of CDO practices
at Morgan Stanley, and New York attorney general Andrew Cuomo began
an investigation of eight major financial institutions concerning their role in
rating CDOs. The Justice Department did seem to have learned a lesson from
its failure to convict two Bear Sterns hedge fund managers that had presided
over the failed hedge funds—that was one of the early signals that a subprime
meltdown was under way. The department announced in May 2010 that it
would not be bringing criminal charges against the AIG executives who were
responsible for the derivative product losses that caused AIG to fail.
The SEC’s publicity efforts were given a setback when it was revealed that
the commission had split on party lines in a 3-2 vote to approve the action
against Goldman Sachs, which is unusual, suggesting that politics were at play.
It was also reported that Robert Khuzami, the head of the SEC Division of
Enforcement had supervised lawyers working on synthetic CDO deals while
he was the general counsel of Deutsche Bank, a Goldman competitor and one
of the leading issuers of these instruments. Criticism was also directed at the
SEC because the agency filed the case during the trading day without advance
notice to Goldman, resulting in a hammering of Goldman’s stock. Normally,
defendants are given a courtesy call and an opportunity to settle the case
before public announcement, unless there is some need for immediate action
to protect investors. There appeared to be no need for haste in the Goldman
case because the agency had been sitting on the case for months. Goldman
lawyers had made an inquiry as to its status before the filing but received no
response. Moreover, in cases where there is a need for urgency, the SEC will

seek temporary or preliminary injunctive relief from the court. No such relief
was sought here.
The timing of the filing of the Goldman case was also found to be “suspi-
cious” by the SEC inspector general (IG) because it conveniently diverted
attention from a recently published report by the IG on the agency’s failure
to uncover the giant Stanford Ponzi scheme and misconduct by a senior staff
member in connection with that case. In another report published a few days
after the filing of the case against Goldman, the IG reported that high ranking
SEC staff members spent considerable time watching pornography on their
government computers during the subprime crisis. Thirty-three SEC staff
members were involved in that activity, including seventeen employees mak-
ing between $99,000 and $220,000 per year. One attorney spent up to eight
hours a day watching porn, and an SEC accountant had tried to access porn
sites 16,000 times.
The SEC’s charges against Goldman Sachs seemed to be taken from a
popular book called The Big Short written by Michael Lewis that was highly
critical of Goldman’s role in underwriting CDOs. The SEC accused Goldman
and one of its employees, Fabrice Tourre, of fraudulently arranging a synthetic
CDO squared transaction called ABACUS 2007-AC1, a part of which was
sold to IKB Deutsche Industriebank AG (IKB). A synthetic CDO squared is a
CDO that uses other CDOs as a performance measure only; it does not include
the actual CDOs or their underlying mortgages.
The SEC alleged that Goldman did not tell IKB, or its Portfolio Selection
Agent, ACA Management LLC (ACA), that the subprime CDOs used as a
portfolio reference in the ABACUS transaction were subject to the approval of
hedge fund manager John Paulson. He later became famous for having made
$5.7 billion personally during 2007 and 2008 by betting against subprime
mortgages. IKB had other problems. Its CEO, Stefan Ortselfen, was convicted
of issuing a press release on July 20, 2007, that falsely assured its sharehold-
ers and investors that it had very little exposure to the U.S. subprime market.
IKB nearly collapsed a week later and had to be bailed out with loans from
the German government of over $13 billion. Ortselfen was given a ten-month
suspended sentence by a German court and fined $127,000.
The SEC claimed that the omission of Paulson’s role was important because
he was taking a short position against those CDOs through CDSs written by
Goldman Sachs. Although Paulson made nearly $1 billion from the transactions
that were the subject of the SEC’s charges, the SEC did not sue him. Paulson
was not charged because he had made no misrepresentations to the investors
in the synthetic CDOs, a requirement imposed recently by the Supreme Court
in some Enron-era litigation that rejected “scheme” liability for those partici-
pating in an accounting fraud but not making misrepresentations directly to
investors. This gap allowed Paulson to keep his $1 billion in profits, which
he subsequently used to make large gains through investments in gold before
suffering losses by betting on the U.S. economic recovery.

A few internal Goldman emails were published that were embarrassing,

including one by Tourre, in which he stated he had “managed to sell a few
abacus bonds to widows and orphans that I ran into at the airport, apparently
these Belgians adore synthetic abs cdo2.” However, Tourre and a senior rep-
resentative for Paulson testified that they had not misled ACA about Paulson’s
short position.
There were other problems with the SEC’s case. ACA knew that Paulson
was involved in the transaction and that there was no position in the ABACUS
transaction in which Paulson could participate other than being short. ACA also
dealt directly and independently with Paulson in negotiating the mortgages that
would be included in the synthetic portfolio. ACA met separately with Paulson
representatives and rejected many of Paulson’s proposed portfolio selections
after rigidly testing them for performance. ACA also proffered CDOs of its
own for inclusion in the reference portfolio. ACA, and not Goldman Sachs, was
responsible for the disclosure of its role in the private placement memorandum
given to IKB. ACA stated there that it had acted independently in selecting the
CDOs for the referenced portfolio in the ABACUS transaction, and there was
no reason to believe that was not the case, as seen from these negotiations.
Still another flaw in the SEC’s case was that numerous courts had held that
a party need not disclose information that is already publicly available. In this
case, it was widely reported in the press, including the Wall Street Journal, the
New York Times, the Financial Times, Euromoney magazine, and the Sunday
Telegraph in London, that Paulson had been making a $1 billion bet against
subprime mortgages for some time before the ABACUS transaction closed
and that he was making incredible profits. A popular hedge fund newsletter,
the Alternative Investment News that is published by Euromoney, also reported
in the summer of 2006 that Paulson was forming a fund to short the subprime
market. It followed up with a report in September 2006 that Paulson had in
fact created such a fund. Paulson was even reported to have boasted that he
doubled his money by shorting the subprime mortgage market some six weeks
before the ABACUS 2007-AC1 deal closed. Several of these reports in the
press were also made before the Goldman Sach’s management committee
approved the ABACUS transaction. Goldman Sachs thus had no reason to
believe that ACA was uninformed that Paulson was short.
Goldman Sachs settled the SEC ABACUS case on July 15, 2010, agreeing
to pay $550 million, most of which went to the alleged victims. The case was
settled on the same day that the president’s massive financial reform legisla-
tion was passed. This was the largest fine ever imposed by the SEC on a Wall
Street firm, but was generally viewed as a victory for Goldman because ana-
lysts had been predicting a fine of $1 billion or more for any settlement. The
press also pointed out that the fine that was levied constituted only fourteen
trading days of profit for Goldman. In addition, the SEC agreed as a part of
the settlement to drop its intentional fraud charge, and Goldman admitted
only that it made a “mistake” in not disclosing Paulson’s role to IKB. The

SEC approved the settlement in another 3-2 vote, because the Republican
commissioners could not understand why such a large fine was merited for
a simple mistake that was not fraudulent. The SEC also agreed not to bring
other cases it had under review against Goldman, which was another consid-
erable victory for the firm.
Goldman had to warn its employees not to publically gloat over the terms of
the settlement. The market agreed with this assessment and Goldman’s stock
jumped sharply on the news of the settlement. No Goldman Sachs executives
had to resign as a result of the settlement, and it appeared that Lloyd Blank-
fein’s position as CEO had been strengthened. However, Fabrice Tourre was
thrown under the bus by Goldman. He was not a part of the settlement, and
he continued his vow to fight the charges.
The SEC received another embarrassing setback shortly after settling the
Goldman case when the Court of Appeals for the District of Columbia struck
down SEC rules that required insurance annuities to register under the federal
securities laws. The court held that the SEC had acted in an arbitrary and capri-
cious manner in adopting those rules because the state insurance commissioners
already regulated such products. Subsequent legislation also precluded the SEC
from regulating those products. A few weeks later, the same court of appeals
struck down an SEC approval of an NYSE Arca rule mandating charges for
access to its proprietary data. The court held that the SEC did not adequately
explain or support its action on the rule.
The SEC then counterpunched with a high-profile case charging Sam and
Charles Wyly with a $550 million fraud charge. The suit claimed that the broth-
ers hid funds offshore in order to avoid paying taxes. The brothers responded
that they were only deferring taxes and that the arrangement at issue had
been cleared by their lawyers, one of whom was in prison on other charges.
The Wylys also fired back with a front-page interview in the New York Times
in which they accused the SEC of playing politics by bringing the case. The
SEC also began an aggressive program of rulemaking for all matter of things
in order to boost its image as a regulator. One proposal would require the is-
suers of asset-backed securities to retain at least 5 percent of each offering
on its books. However, it was the holding of such securities by the financial
institutions issuing them that caused the subprime crisis.
Dodd-Frank Wall Street Reform and Consumer Protection Act
Congress passed its overhaul of financial regulation on July 15, 2010. That
legislation had been stalled in Congress for many months, and a $19 billion
surprise tax on banks was included in the proposed legislation at the last minute
as a way of paying for the costs of the additional regulation it would impose.
That unexpected tax bought some votes, but the death of Senator Robert Byrd
on June 28, 2010, threatened the already razor-thin support needed to pass the
bill over Republican objections. The Democrats then dropped the new tax and

substituted a provision for accelerating the end of the TARP program as a way
of offsetting some of the costs of the new legislation, allowing them to draw
a critical Republican vote. The House and Senate versions of the financial
services reform legislation were then resolved among the Democrats after a
marathon twenty-two hours of negotiations.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
(Dodd-Frank Act) was massive in scope. Totaling over 2,300 pages, it touches
on nearly every aspect of finance and constitutes a governmental intrusion into
Wall Street unseen since the 1930s. President Obama pointedly signed the
bill into law in the Ronald Reagan office building at the International Trade
Center in Washington, DC, signaling that Reagan’s deregulation efforts were
being reversed.
Dodd-Frank was a grab bag of reforms that often had little or nothing to
do with the subprime crisis. For example, each financial regulator is required
by the legislation to create an Office of Minority and Women Inclusion that
is to act as a sort of diversity cop over the hiring and employment practices
of financial services firms. Despite its size, Dodd-Frank offered no assurance
that another financial panic will not occur in the future. Indeed, that legislation
ignored the most critical issues of subprime lending by Fannie Mae and Freddie
Mac. Instead, Congress promised to review their status in the future. In that
regard, Treasury Secretary Geithner in an address on August 17, 2010 indicated
that Fannie Mae and Freddie Mac were responsible for much of the mortgage
lending in America because private lenders had pretty much abandoned the
field. This was a signal that the government intended to continue to subsidize
mortgages by guarantying them and exposing itself to risks engendered by
politically motivated lending policies.
The Dodd-Frank Act sought to address the “too big to fail” problem by cre-
ating a Financial Stability Oversight Council (FSOC) chaired by the secretary
of the treasury. The other voting members on the Oversight Council are the
heads of the Fed, the OCC, the FDIC, the SEC, the CFTC, the Federal Housing
Finance Agency, the National Credit Union Administration, a new Bureau of
Consumer Financial Protection and an independent member appointed by the
president and knowledgeable about insurance. The council also has a number
of non-voting (advisory) members, including the heads of a new Federal In-
surance Office and the Office of Financial Research, and delegates selected
by state insurance, banking and securities commissions. The council is to act
by majority vote, except for some actions a 2/3 vote is required including the
vote of the chair. This structure guarantees that jurisdictional debates will be
decided by politics, rather than economics or efficiency. The unwieldy nature
of FSOC will also assure that there will be no fast action taken in future crises,
which means that the economy may well collapse as these many regulators
express their always conflicting opinions on what course to take.
The purpose of the Council is to identify risks to the financial stability of the
United States that could arise from the distress, failure, or ongoing activities, of

large, interconnected bank holding companies or nonbank financial companies,

or that could arise outside the financial services marketplace. In response to the
backlash from the TARP legislation, the council is also charged with eliminat-
ing any belief on the part of shareholders, creditors, and counterparties that
the federal government will bail out a firm that is about to fail. The council is
also tasked with a number of other duties, including information gathering and
resolution of jurisdictional disputes among its members. The council is to be
assisted by the newly created Office of Financial Research in the Department
of Treasury that is to gather and analyze financial data.
The Dodd-Frank legislation extends the power of the Fed over large nonbank
financial companies, such as AIG, if they are determined to pose a systemic
threat in the event of their failure. The council is authorized to require regula-
tion by the Fed of nonbank financial companies by a 2/3 vote of the council,
including the vote of the chair. That vote is to be based on a determination that
there would be negative effects on the financial system if the company failed
or its activities would pose a risk to the financial stability of the U.S. The Fed
is authorized to require reports and conduct examinations of the activities of
nonbank financial companies and recommend enforcement actions by their
functional regulator or take its own action if the functional regulator fails to
respond. The Fed is further authorized to establish prudential risk standards
for these nonbank financial companies.
The Fed may require nonbank financial companies to establish risk com-
mittees and to undergo financial stress tests to determine their vulnerability to
adverse economic events. The Fed may also establish leverage ratios limiting
debt to equity of no more than 15 to 1. The council may order the breakup
of large complex companies or require divestment of some of a company’s
holdings upon a 2/3 vote, including the chair, if the company poses a grave
threat to the financial stability of the United States. This extraordinary power
is to be used only as a last resort.
The Dodd-Frank legislation sought to limit future bailouts of failing finan-
cial institutions, and the existing TARP program was reduced to $550 billion.
The Fed, in consultation with the Treasury Department, is required to adopt
regulations designed to assure that any emergency lending program or facility
is for the purpose of providing liquidity to the financial system, and not to aid
a failing financial company. The collateral given as security for emergency
loans must be sufficient to protect taxpayers from losses, and any such program
must be terminated in a timely and orderly fashion.
Upon the written determination of the FDIC and the Fed, the FDIC is
authorized to create a widely available program to guarantee obligations of
solvent insured depository institutions or solvent depository institution holding
companies (including any affiliates thereof). This authority may be exercised
during times of severe economic distress (a “liquidity event”), except that
a guarantee of obligations may not include the provision of equity in any
form. The maximum amount of such a guarantee program is to be set by the

president and approved by Congress by joint resolution. A liquidity event is

defined as an exceptional and broad reduction in the general ability of financial
market participants to sell financial assets without an unusual and significant
discount; or to borrow using financial assets as collateral without an unusual
and significant increase in margin; or an unusual and significant reduction in
the ability of financial market participants to obtain unsecured credit. These
were all events that occurred during the subprime crisis.
The council may order large financial holding companies to submit a resolu-
tion plan (a living will) on how the bank will be liquidated or otherwise resolved
in the event of its failure. The legislation provides for the orderly liquidation
of covered financial companies. The procedure involves the appointment of
the FDIC as receiver of covered financial institutions. The FDIC must appoint
SIPC to act as trustee for the liquidation of a broker-dealer.
The Dodd-Frank Act authorized bank regulators to establish leverage re-
quirements as well as risk-based capital requirements for banks. A study was
ordered on what components may properly constitute Tier 1 capital. The use of
trust preferred securities as Tier-1 capital is no longer permitted, and existing
trust preferred securities (a popular hybrid debt/equity instrument) are to be
phased out. Dodd-Frank requires the Fed to consider the risk to the economy of
bank mergers. Concentration limits are imposed. Financial company mergers
are thus prohibited if the consolidated liabilities of the merger would exceed
10 percent of the consolidated liabilities of all financial companies. A similar
10 percent test for deposits was adopted.
The Fed was also given broader examination authority over bank and sav-
ings holding companies. Securities holding companies that are required by
a foreign regulator to be subject to comprehensive consolidated supervision
may register with the Fed. Dodd-Frank required exposures from derivatives to
be included in lending limits. The new legislation also added further regula-
tory supervision over payment, clearing and settlement systems. The Fed was
given an enhanced role in the supervision of risk management standards for
systemically important payment, clearing, and settlement activities by financial
institutions, which will be regulated as designated financial market utilities.
A debate had broken out over the accountability of the Fed during the sub-
prime crisis. Some critics and members of Congress wanted it to be audited,
but supporters of the Fed thought this might impair its independence. Under
Dodd-Frank, the Government Accountability Office (GAO) was directed to
conduct a one-time audit of all Federal Reserve emergency lending that took
place during the subprime crisis. The GAO was also given ongoing authority
to audit emergency lending, discount window lending and open market trans-
actions. The Dodd-Frank legislation additionally created a vice chairman for
supervision, who will be a member of the Fed designated by the president to
develop policy recommendations regarding supervision and regulation for the
Fed. Directors elected by member banks to represent member banks will no
longer be allowed to vote for presidents of the Federal Reserve Banks.

Dodd-Frank abolished the Office of Thrift Supervision (OTS). The OTS

authority over savings and loan holding companies was transferred to the
Fed, and the OCC received OTC’s powers over federal savings associations.
The FDIC was authorized to make assessments to fund its insurance program
based on asset size less tangible equity, and pro-cyclical assessments were
prohibited. FDIC insurance was increased permanently to $250,000 except
that there was no coverage limit on non-interest bearing accounts.
Dodd-Frank adopted a modified version of the Volcker rule. Hedging activi-
ties using derivatives are permitted. Banks may also invest up to 3 percent of
their Tier 1 capital in hedge funds and private equity funds, but such invest-
ments may not exceed 3 percent of the assets of the hedge fund or private
equity group in which an investment is made. Nonbank financial firms are
subject to additional capital requirements and quantitative limits with respect
to their proprietary trading and hedge fund and private equity investments.
Dodd-Frank prohibits proprietary trading by banks, but brokerage, market
making, and hedging activities are still allowed.
This meant that most banks would not be severely affected by the remnants
of the Volcker proposal. Two exceptions were Goldman Sachs and Morgan
Stanley, which converted to bank holding company status during the subprime
crisis. They will be required to withdraw billions of dollars of firm funds invested
in hedge funds and private equity, raising the issue of whether those two firms
should reconvert from bank holding company to broker-dealer status. Dodd-
Frank, however, added a “Hotel California” provision (after the Eagles song
about the hotel “you can check out of but never leave”) that prohibits regulatory
conversions by bank holding companies, such as Goldman and Morgan Stanley,
that received TARP funds. JPMorgan also had to close its proprietary unit.
Dodd-Frank further addressed asset-backed securities. Originators will be
required to retain an interest in their securitizations, up to 5 percent. “Qualified
residential mortgages” were exempt from this risk retention requirement. Such
qualified mortgages would not allow balloon payments, negative amortization,
prepayment penalties, interest-only payments, and other features that have
been demonstrated to exhibit a higher risk of borrower defaults.
Elusive Systemic Risk
The effort in Dodd-Frank to isolate systemic risk is an elusive goal and misguided.
As regulators force financial institutions to curb one product because bureaucrats
conclude that they pose excessive risk, finance will be forced into other fields
that create a new systemic risk, unknown to a clueless bureaucracy. Worse still,
the government will try to manage the companies that pose systemic risk, to set
their compensation policies, and to select their leaders, who will undoubtedly
be friends of the regulator (that is, former regulators with little or no business
experience). This is foolishness. It will not prevent or detect market panics. There
will continue to be periodic downturns, panics, and business folly.

As Robert Rubin, the former secretary of the treasury, noted in his autobi-
ography, there is a tendency in human nature to engage in “financial excess,”
and humans have a “remarkable failure to draw lessons from past experience.
. . . The proclivity to go to excess is a phenomenon of collective psychology
that seems to repeat itself again and again.”50 Ironically, Rubin, who became
a senior executive at Citigroup, was forced to resign because it was reported
in the press that he had encouraged that bank to change its business model
and take on more risk. Citigroup did so and nearly failed during the subprime
crisis, surviving only on government bailouts.
Two business models for financial services firms emerged as successful
during the subprime crisis: Goldman Sachs, as an investment banker, and
JPMorgan Chase, as a commercial bank, but they were opposites. Goldman
Sachs became one of the most successful firms in Wall Street history by
deliberately incurring large risks, but with careful management. In contrast,
the JPMorgan Chase business model was to build a “fortress” balance sheet
that would withstand the most severe economic downturn, which meant more
limited risk taking. So which business model will the bureaucrats try to stamp
out as posing excessive risk? The correct answer is “Goldman Sachs.” But
Goldman Sachs has proved to be a successful business model that should have
been allowed to continue.
There is also irony here. Limited risk models are equally as likely to fail as
those incurring more risk. Indeed, the business landscape is littered with the
carcasses of businesses that matured and avoided risks, to their detriment. The
automakers avoided innovation because it is risky; they merely offered slightly
differing versions of the same models with only an occasional new product.
That business model had been faltering for years and failed spectacularly
during the subprime crisis. Staid Eastman Kodak, which also has a renowned
politically correct corporate governance system, has avoided risk at all costs,
and it is a poster child for the results of avoiding risks. Eastman Kodak is a
failed enterprise that did much to undermine the economy of Rochester, New
York by avoiding risks and ignoring competition.
The SEC, CFTC and Derivatives
Dodd-Frank reacted to the SEC’s case against Goldman Sachs by prohibiting

conflicts of interest for a one-year period on the part of underwriters or place-
ment agents after the issuance of asset-backed securities, including synthetic
CDOs. However, underwriters may engage in hedging and market making
activities. Dodd-Frank also requires the Government Accountability Office
to prepare a report exploring whether the Supreme Court’s decision striking
“scheme” liability, which allowed John Paulson to escape the SEC’s action
against Goldman Sachs, should be overturned by Congress. Another report
was required on whether private right of actions should be allowed against
persons who aid or abet a violation of the federal securities laws, an action dis-

allowed by another Supreme court case and which stopped many class actions
against accountants and lawyers, and also helped Paulson avoid charges in the
SEC case. Dodd-Frank added aiding and abetting liability, which is already
contained in the Securities Exchange Act of 1934, the Securities Act of 1933
and the Investment Advisers Act of 1940. The standard of proof for intent for
aiding and abetting was lowered from “knowingly” to “recklessly.”
The Treasury Blueprint for regulatory reform issued in March 2008 had recom-
mended a merger of the SEC and the CFTC. It was reported in May 2009 that,
while the Obama administration supported a merger of the two agencies, it was
not prepared to take on a fight between the two congressional committees over-
seeing those agencies.51 Dodd-Frank, therefore, did not merge the two agencies,
a merger that would have diluted the SEC’s authority. Another gift to the SEC
was an increase in its budget to $1.3 billion in 2011 and to $2 billion in 2014.
The SEC’s many blunders did not pass entirely unnoticed. Dodd-Frank
subjected the agency to some limited oversight by the OCC, which must
audit and report on the SEC’s effectiveness every three years. Other manage-
ment problems at the SEC were addressed in the legislation, including the
exceptionally high rate of employee turnover at the agency, which has had the
effect of robbing it of needed expertise. An employee hotline was required so
that misconduct could be discovered more quickly. Dodd-Frank also created
a “Council of Inspectors General” composed of the inspectors general at the
financial services regulators, including the Treasury, SEC, and the Fed. This was
intended as another means to strengthen oversight of financial services regula-
tors. In a response to the massive Madoff Ponzi scheme that was conducted
for years despite the SEC’s supervision, the agency was directed to conduct a
study of how it could enhance its examinations of investment advisers.
A new Office of Investor Advocate was created at the SEC, and it was
to be assisted by the appointment of an ombudsman to act as that advocate.
This would undoubtedly lead to more corporate governance reforms. A study
on the financial literacy of retail investors was ordered. The SEC was also
authorized to restrict mandatory arbitration of retail customer claims. Most
brokerage firms currently use such arbitration in order to avoid costly litigation
of customer complaints in court. A study on the conflicts of interest among the
departments of investment banking firms was also ordered, another throwback
to Eliot Spitzer’s crusade against the financial analysts during the Enron-era
scandals.
The SEC was directed by Dodd-Frank to conduct a study of whether custom-
ers of broker-dealers should be given the same protections of fiduciary duties
as those given to clients of investment advisers. The SEC was authorized to
impose such a requirement after conducting that study, but there was to be
no continuing fiduciary duty after personalized advice is given. As a practical
matter, this would not change the existing duties of broker-dealers who may
not recommend securities that are unsuitable for their customers. In any event,
the lack of such fiduciary duties had nothing to do with the subprime crisis

and as limited by Dodd-Frank will have no substantive effect, except to set the
stage for more abusive litigation and encourage disappointed investors to sue
their brokers. A group of the largest Wall Street firms agreed to support this
proposal. That support was probably due to the group’s desire to sell fee-based
brokerage accounts, a product that a federal court ruled required fiduciary
duties and could not be sold by broker-dealers unless they were registered as
investment advisers under the Investment Advisers Act of 1940.52
The SEC was also given the authority it sought over securities based de-
rivatives. Before passage of Dodd-Frank, the chairs of the SEC and the CFTC
reached an agreement to divide their jurisdiction by giving the SEC control
over derivatives related to publicly traded securities and credit-default swaps
(CDSs), leaving the CFTC with jurisdiction over derivatives related to other
commodity products.53 On August 11, 2009, the Obama administration submit-
ted a 115-page legislative proposal to Congress on this division of jurisdiction.
Dodd-Frank acted on that proposal by regulating the previously unregulated
swaps market. The SEC was given jurisdiction over security-based swaps and
the CFTC jurisdiction over other swaps, except that joint regulatory author-
ity is given to both agencies for “mixed” swaps that have elements of both
securities and commodities. Most swaps will now be exchange traded and
cleared through a regulated central counterparty. Customer funds associated
with exchange-traded swaps must be held in segregated accounts. Portfolio
margining was encouraged, an arrangement by which margin may be reduced
through offsetting commitments on another exchange.
Federal assistance to any swap related transaction or entity is prohibited,
an apparent effort to assure no more bailouts like AIG. However, insured
depositories are allowed to engage in a number of swaps activities such as
hedging and acting as a credit-default swaps dealer if the swaps are centrally
cleared. The legislation allows regulators to impose capital and margin re-
quirements on swap dealers and major swap participants, but not end-users.
Dodd-Frank directs the CFTC to establish position limits on trading of swaps.
It establishes a code of conduct for all registered swap dealers and major swap
participants when advising a swap entity. When acting as counterparties to a
pension fund, endowment fund, or state or local government, swap dealers
are to have a reasonable basis to believe that the fund or governmental entity
has an independent representative advising them.
Futures commission merchants, who act as brokers for commodity trad-
ers, are required to appoint a chief compliance officer and assure that there
are appropriate informational barriers (“Chinese Walls”) between analysts
and others in order to prevent conflicts of interest. This was another leftover
reform from the Enron-era scandals brought to the fore by New York attorney
general Eliot Spitzer in the securities industry. Rewards for whistle-blowers
are provided from successful recoveries. The CFTC’s antimanipulation au-
thority for false reporting was expanded to swaps. The legislation also bars
“disruptive” practices identified as conduct that demonstrates intentional or

reckless disregard for the orderly execution of transactions during the closing
period on an exchange, or which constitutes “spoofing” (bidding or offering
with the intent to cancel the bid or offer before execution).
Once again, the need for this regulation is not evident. The CDS market oper-
ated efficiently throughout the subprime crisis. The Lehman CDSs were settled
promptly and in full. The problems at AIG were not attributable to CDS. The
event that triggered the credit downgrades at AIG, and caused what amounted to a
bank run, was the fair-value accounting write-offs for AIG’s exposure to the Super
Senior tranches of the subprime CDOs. As described above, that was a regulatory
problem, for which regulators and the FASB must bear responsibility.
Another regulatory target was to centralize the clearing and settlement of
swaps, a process engaged in by clearinghouses on regulated exchanges and
which provides transparency in the amount and nature of the trading on the
exchange. SEC chairman Christopher Cox had sought authority from Con-
gress to regulate the CDS market in September 2008, saying, “The regulatory
black hole for credit-default swaps is one of the most significant issues we are
confronting in the current credit crisis, and it requires immediate legislative
action.”54 He argued that the market lacked transparency and was ripe for fraud
and manipulation, of which very little could be found.
The claim of lack of transparency became a new rationale for more regula-
tion. Yet, no one could explain how transparency could have prevented the
subprime crisis, or how it would add anything of value to the CDS market, and,
worse still, nobody asked that question. Cox’s claims also showed just how
out of touch his agency was with financial markets. Apparently without Cox’s
knowledge, the Depository Trust and Clearing Corporation (DTCC), which the
SEC regulates, established a Trade Information Warehouse (Warehouse) before
the subprime crisis that was “the only global repository and centralized post-
trade processing infrastructure for over-the-counter (OTC) credit derivatives.
The Warehouse maintains the vast majority of CDS contracts in the market
place.”55 Thus the information sought by Cox was there for the asking, if only
he had known to ask. Indeed, the DTCC was able to assure the market that
the CDS exposures from the Lehman Brothers bankruptcy were limited and
manageable, which allayed concern among market participants.
To be sure, concern was expressed even before the subprime crisis (in 2005)
in a three-hundred-page report prepared by a former New York Fed president,
Jerry Corrigan, over settlement procedures for credit derivatives. Many credit
derivative dealers were behind in their trade confirmations, and some assigned
their positions to other dealers without the permission of the counterparty. The
industry addressed those problems after the Corrigan report was filed, and by
most accounts the CDS market operated smoothly during the subprime crisis.
The outstanding notional amount of CDSs, which totaled over $65 trillion in
2007, fell to an estimated $58 trillion in 2008 as the cost of these instruments
increased during the crisis, but that was a normal market reaction.
Treasury Secretary Geithner announced the administration’s plan to regulate

OTC credit-default swaps and other OTC derivatives by requiring them to be

cleared through a central clearinghouse. This was not surprising. While presi-
dent of the New York Fed, Geithner had been behind an industry-supported
effort to create a central CDS clearing facility. A Wall Street Journal editorial
expressed concern over this proposal because it would centralize and social-
ize risk. The newspaper also objected to the proposed reliance by the New
York Fed on credit ratings as a basis for access to the clearing facility. The
Wall Street Journal was additionally critical of government efforts to create a
regulated CDS market. The editorial noted that the market for CDSs operated
well despite the failure of Lehman Brothers and AIG.56 Moreover, outstanding
CDSs on bankrupt General Motors’ debt of $35 billion were only $2.2 billion
in exposure and were easily settled.
Although the Presidential Working Group supported Geithner’s concept
for central clearing of CDSs, a jurisdictional fight broke out among the SEC,
the CFTC, and the New York Fed over who would approve and regulate such
clearinghouses. These regulators tried to resolve this dispute through a memo-
randum of understanding that promised enhanced cooperation and information
sharing among the Fed, the SEC, and the CFTC, upon the development of such
a facility. This truce did not last long, and the turf war continued.
The SEC claimed that CDSs were securities subject to its jurisdiction. Using
that regulatory role, the SEC proposed to exempt from most of its regulation
CDS clearinghouses that complied with its standards, including the exclusion
of non-eligible swap participants.57 The SEC made another effort to bring
CDS under its wing by filing an inside-trading case in May 2005. The agency
charged that Jon-Paul Rorech, a bond salesman at Deutsche Bank, had passed
inside information to Renato Negrin, a hedge fund manager at Millennium
Partners, who then used the information to make a quick profit of $1.2 mil-
lion. In the scheme of things, this was hardly a massive fraud, but the SEC
used it to justify the need for more regulation. The SEC was embarrassed once
more, however, after a judge dismissed that case, finding that the SEC had
no evidence to support its claims. The defendant, Jon-Paul Rorech, was soon
thereafter hired by UBS AG.
In the meantime, the industry continued working on the creation of a
central clearinghouse. A problem that had to be surmounted in clearing
OTC derivatives is that their terms are often non-uniform, unlike futures
and options trading on exchanges. This makes it more difficult for the clear-
inghouse to assess its exposure when acting as a counterparty. Models have
been developed that measure unique instruments, but difficulties remain.
A model for OTC derivatives was developed by the IntercontinentalEx-
change (ICE), which cleared what were effectively OTC derivatives, albeit
with uniform terms. The legislation proposed by the Obama administration
sought to require “standardized” OTC swaps to be registered with a regulated
clearinghouse. A standardized swap would include any contract accepted by
a clearinghouse and other contracts similar to those cleared by a clearing-

house, but many questions were left unanswered over how “standardized”
CDS status would be attained.
Adding to the regulatory expansion into this once-unregulated market
was an announcement in July 2009 that the Antitrust Division in the Justice
Department was focused on the CDS market. In particular, the division was
investigating Markit Group Holdings, which was a company formed by a con-
sortium of banks to collect pricing information, which was used to create the
ABX index to track subprime mortgages, as well as the CDX index for CDSs.
Banks participating in this enterprise included Goldman Sachs and JPMorgan
Chase. New York attorney general Andrew Cuomo and U.S. attorney Michael
Garcia in Manhattan reached an agreement in October 2008 to jointly inves-
tigate the CDS market, even though it showed few signs of illegal activities.
Cuomo investigated whether swap dealers were manipulating the market for
CDS. Eric Dinallo, the New York State superintendent of insurance (a protégé
of Eliot Spitzer, who was planning to run for attorney general), jumped in
and announced that a portion of the CDS market was subject to regulation as
insurance. He was supported in that effort by Spitzer’s successor as governor
of New York, David A. Paterson. However, Dodd-Frank excluded swaps from
the definition of insurance.
The Dodd-Frank Act almost completely reworked the landscape for swaps,
subjecting them to intense regulation where there had been little or none before.
The Commodity Futures Modernization Act of 2000 exempted most swaps
from regulation, but that course was abandoned in Dodd-Frank. Dodd-Frank
requires swap participants to be eligible contract entities (institutions or wealthy
individuals) if the swap is not traded on a regulated contract market. Dodd-
Frank also requires swaps to be cleared by a registered derivatives clearing
organization (DCO) unless the CFTC rules otherwise. Swaps cleared by a DCO
must be maintained at a registered futures commission merchant subject to
CFTC segregation requirements for customer funds. Segregation may also be
demanded for non-cleared swaps. The CFTC was allowed to regulate margin
requirements when necessary to protect the integrity of derivative clearing
organizations, a power previously withheld from that agency for futures.
Dodd-Frank requires the CFTC to make public disclosures concerning
the volume and nature of cleared swaps, but disclosure of trader identity is
restricted. The act requires the reporting of non-cleared swaps to registered
“swap data repositories” or (if the former doesn’t accept them) to the CFTC.
Firms acting as swap dealers and major swap participants must register with
the CFTC before they can engage in swap transactions. Firms engaged in
securities-based swaps must register with the SEC. The CFTC and SEC are
required to establish capital and margin requirements for the swap entities they
regulate. Swap dealers and major swap participants are required to maintain
trading records and disclose certain material risks to counterparties. The CFTC
may also require the registration of foreign boards of trade that allow U.S.
traders to access their electronic trading systems.

Hedge Funds
The subprime crisis refocused regulatory attention worldwide on hedge funds,

even though they weathered the storm much better than the large highly regu-
lated commercial and investment banks did. In testimony before Congress
on March 26, 2009, Geithner indicated his support for requiring registration
of hedge funds. Ironically, he cited the massive fraud by Bernard Madoff as
evidence of the need for registration. However, Madoff had registered with the
SEC as an investment adviser in 2006 as the result of an SEC rule requiring
hedge funds to register as investment advisers. That rule was later stricken by
a federal court but, unlike many hedge funds, Madoff did not deregister his
firm and continued his fraud under the supervision of the SEC. In imposing
that registration requirement, the SEC had claimed that registration of hedge
funds would allow it to detect and prevent fraud at such operations. Yet the
SEC was clueless about Madoff’s scheme, the largest financial fraud in world
history. The SEC’s inspections of Madoff’s investment adviser operations
failed to uncover any fraud, despite several warning signals.
Ignoring that bit of history, Mary Schapiro, the head of the SEC appointed
by the Obama administration, vowed at her confirmation hearings to seek
greater regulation of hedge funds in order to make them more transparent and
accountable. Schapiro sought regulation that went beyond the administration’s
registration proposal. She wanted not only to renew the registration require-
ment but to also impose a new requirement that hedge funds be subject to
books and records inspection by that agency, even though such measures had
not uncovered the Madoff fraud.
The Dodd-Frank Act responded to those requests by requiring hedge fund
managers to register with the SEC as investment advisers if the assets they
manage in the United States exceed $100 million. Venture capital advisers are
exempted from registration with the SEC. Smaller hedge funds are subject
to state regulation. Commodity trading advisors registered with the CFTC
must also register with the SEC if their advice is primarily security related.
Registered hedge fund managers must keep books and records that disclose
the amount of assets under management, the degree of leverage in the funds
they manage, any “side pocket” arrangements that give some investors greater
rights than others and trading practices. The SEC is authorized to make peri-
odic and surprise examinations of registered hedge funds. It was also ordered
to study the effects of short sales, a favored trading technique of hedge funds,
and to consider the feasibility of a program that would require orders to be
marked as short or long.
The European Union sought even tougher regulation of hedge funds and
private equity, including capital requirements, risk management requirements,
and a requirement to regularly report their investments, performance, and risk.
That proposal was opposed by the United States and Great Britain. Especially
controversial was a proposal that would have effectively excluded U.S. hedge

funds from operating in Europe. After those protests the European Union
postponed a vote on the new rules.
The Rating Agencies—Shoot the Messenger
Lloyd Blankfein, the CEO at Goldman Sachs, published an op-ed piece in the
Financial Times in which he identified risk management flaws in the financial
system that he believed had laid the groundwork for the subprime crisis. Blank-
fein asserted that many financial institutions had erred in outsourcing their risk
management to the rating agencies. He contended that the rating agencies had
diluted their triple-A rating by giving that rating to more than 64,000 structured
finance instruments, while only twelve operating companies in the world had
such a rating. Where financial services firms did their own modeling, they failed
to take into account multiple standard deviations, ignoring the possibility of a
hundred-year storm. Blankfein pointed to flawed risk models that erroneously as-
sumed positions could be fully hedged and that failed to capture off-balance-sheet
risk. He also thought that the industry had not been able to keep up operationally
with the complexity of the risks presented by new financial instruments.58 That
was sound criticism, but what was the alternative?
The rating agencies, including Moody’s, Standard & Poor’s, and Fitch, had
become the arbiters of the interest rate paid by companies when borrowing
money. A company’s credit status, as perceived by the ratings agencies, also
measured its acceptance as a counterparty with other businesses. The higher the
rating, the more exposure a counterparty would accept in trading or dealing with
the rated company. A triple-A rating evidenced the rating agencies’ belief in a
high likelihood that the debtor would not default. Lower ratings, those below
“investment grade,” were considered high-risk “junk” bonds, which indicated
a higher likelihood of default. A lower rating meant more risk to investors, and
they therefore demanded higher interest payments to compensate for that risk,
as well as reduced exposure. It was, consequently, important to the issuer to re-
ceive the highest possible rating for its issues. It was also important to maintain
those ratings because a downgrade would result in a sharp fall in the value of
the bond or other debt instrument being rated and would raise funding costs or
even limit further access to the credit markets. Lower ratings could also impair
the liquidity of instruments, as investors might be reluctant to buy them at any-
thing other than distress prices because of the uncertainty of their performance.
Downgrades can also set off “triggers” in lending arrangements or derivatives
that will require more collateral or accelerated repayment or settlement, which
is what happened at the Enron Corp. when it failed.
The importance of the credit rating agencies grew when government regu-
lators began using their ratings as regulatory tools. Such a role for the rating
agencies dates back to the Great Depression when the Comptroller of the Cur-
rency used their ratings to assess the quality of assets held by banks. The SEC
recognized this role of the rating agencies by designating them as Nationally

Recognized Statistical Ratings Organizations (NRSROs). For example, the

SEC’s net capital requirements used credit rating agency assessments as the
basis for computing “haircuts” (reductions in the value of instruments to reflect
their risk) on fixed income securities, and it limited money market investments
to short-term debt instruments highly rated by the NRSROs. An internal SEC
study found forty-four references to NRSROs in its rules and forms.
Congress also adopted the NRSRO concept by defining an eligible “mortgage-
related security,” in the Secondary Mortgage Market Enhancement Act of 1984, as
being rated in one of the two highest rating categories by at least one NRSRO. In
1995, Fannie Mae allowed the use of a title insurer with a favorable credit rating
from at least one independent credit rating agency. The Federal Deposit Insurance
Act adopted the concept by defining “investment-grade” corporate obligations
as being rated in one of the four highest categories by at least one NRSRO. The
Education Department also uses NRSRO ratings to set eligibility standards for
institutions seeking to participate in student financial aid programs.
The rating agencies employed knowledgeable experts to assess credit qual-
ity, but they had a large field to cover. Moody’s, for example, employed some
1,200 analysts to rate the debt of 100 sovereign nations, 12,000 corporations,
and nearly 30,000 state and municipal offerings, as well as 100,000 structured
finance vehicles. That expertise was also compromised by the fact that the
credit rating agencies had a conflict of interest because of the way in which
they charged fees for their ratings. Starting in the 1970s, the rating agencies
began charging a fee to the company they were rating, which was an induce-
ment to the rating agencies to please the client.
The credit rating agencies’ assessments of creditworthiness did not always
prove reliable, a fact that was apparent long before the subprime crisis. An SEC
investigation found that the sale of Penn Central commercial paper had been
greatly aided by its “prime” rating from the National Credit Office, which was
the highest rating grade issued by that rating agency. The high rating of the
Penn Central commercial paper occurred just before its collapse in 1970. The
SEC found that the rating had been given without adequate investigation.59
Moody’s and Standard & Poor’s had also given the highest rating to the
municipal debt of Orange County, California, just before that county filed
the largest municipal bankruptcy in history due to the speculative trading
operations of the county treasurer, Robert Citron. The rating agencies also
maintained their high rating for Enron until just before its collapse. After the
Enron affair, Congress passed the Credit Rating Agency Reform Act of 2006,60
which required credit rating agencies to register with the SEC and to provide it
with their performance measurement statistics, rating methodologies, a code of
ethics, and financial statements.61 The credit rating agencies were also required
to adopt procedures for the prevention of the misuse of inside information and
to deal with conflicts of interest, such as their fee arrangements. The SEC was
given rulemaking authority to deal with conflicts of interest. Tying practices,
such as requiring payment for additional services in order to obtain or retain a

rating, were prohibited. That legislation did nothing to enhance credit ratings
and did nothing to correct the shortcomings in the ratings methodology that
were at the center of the subprime crisis.
Congress became dissatisfied with the rating agencies once again after they
began a massive downgrading of the subprime mortgages that they had once
rated as triple-A or investment grade. Those downgrades affected thousands of
mortgage securitizations totaling about $1.5 trillion in value. Those downgrades
required the holders of those instruments to mark them down in price. That
action, in turn, imposed losses on those investors. On July 10, 2007, Moody’s
cut ratings on CDOs valued at $5 billion. Between July and August 2008 alone,
Moody’s downgraded nearly 1,000 CDO issues valued at some $25 billion.
By February 2009, the number of downgrades worldwide had reached over
16,000, more than 90 percent of which were CDOs.62
The effect on a securitized issue as a result of a credit downgrade can be
seen from what happened to a Goldman Sachs mortgage-backed securities of-
fering, made in 2006, which included subprime and second mortgages. It was
a $338 million offering, of which $165 million was placed in a tranche that
received a triple-A rating from both Moody’s and Standard & Poor’s. Eight
months after its issuance, and in the midst of the subprime crisis, Moody’s
announced that the offering was placed on credit watch. A few months later,
it reduced the rating from triple-A to Baa, the lowest investment-grade level.
Thereafter, it downgraded that rating to junk bond status and then lowered it
further a few months later. After those downgrades, the value of those securi-
ties fell dramatically and trading in the issue stopped.
The massive number of subprime downgrades suggested that something was
wrong at the rating agencies, which gave the Super Seniors such high ratings
and then switched and downgraded them to junk bond status. Members of
Congress demanded that the SEC investigate Moody’s and Standard & Poor’s
to determine whether they had properly maintained their independence. The
press also criticized Moody’s for becoming too chummy with its structured
investment vehicle (SIV) clients. The Wall Street Journal even faulted one
Moody’s executive for going parachuting with a client. That charge was silly,
but Moody’s had benefited from this lucrative market. Its profits rose by 375
percent over a six-year period, driven largely by structured finance ratings.
Moody’s rated nine out of every ten dollars raised through structured in-
struments. In 2005, its structured finance ratings resulted in revenues of $715
million, which was more than 40 percent of Moody’s total revenues. Moody’s
charged more than $200,000 to write a $350 million mortgage-backed offering,
while a municipal bond offering in the same amount would generate fees of
only $50,000. Standard & Poor’s and Moody’s revenues grew from $3 bil-
lion in 2002 to more than $6 billion in 2007 as a result of structured finance
ratings. Moody’s had the highest profit margin of any company in the S&P
500 for five straight years.
A study released by the SEC in July 2008 found that the rating agencies

had been careless in their approach to rating SIVs. The SEC found that the
rating agencies were understaffed and overwhelmed by the large number of
subprime securitized offerings. The analysts employed by the rating agencies
were also found to have considered the risk of losing business if they did not
give instruments the ratings sought by the issuer. The risks of the subprime
securitizations were often not fully measured by the rating agencies. One
analyst said that: “it could be structured by cows and we would rate it.”
Moody’s discovered in February 2007 that it had committed a computer error
in giving a triple-A rating to “constant proportion debt obligations” (CPDO),
a form of synthetic debt security that was widely sold in Europe. Although it
became aware of the error shortly after the securities were issued, Moody’s did
not correct the rating for more than a year. The market value of those instru-
ments at issuance was more than $1 billion, but their price plunged after the
subprime crisis began. Moody’s was advised in May 2010 that the SEC staff
was recommending an enforcement action for this failure. The charges were
a bit convoluted. The SEC staff claimed that Moody’s filed a false NRSRO
application because this activity did not comport with a code of ethics included
in that application. This so-called “Wells notice” from the SEC caused a sharp
sell-off in Moody’s stock. Standard & Poor’s also experienced a decline.
Some $300 billion in CDOs was in default by February 2009.63 Banks in the
European Union had been badly damaged by the triple-A rated “Super Senior”
subprime CDOs. Their governments turned on the rating agencies, finding them
a convenient scapegoat. The European Commission proposed legislation in
November 2008 that would regulate credit rating agencies through its Commit-
tee of European Securities Regulators. In the United States, Treasury Secretary
Henry J. Paulson stated that he would seek additional regulation of the rating
agencies, including requiring different ratings categories for mortgage-backed
securities, the disclosure of conflicts of interest, and explanation of the basis
for their reviews. He also wanted the rating agencies to assume a more aggres-
sive regulatory role over loan originators. The President’s Working Group on
Financial Markets endorsed this plan.
Moody’s sounded a warning in 2008 that the United States was in danger of
losing its triple-A credit rating in the future because of rising expenditures on
Social Security and Medicare. Such a downgrade would be a disaster for federal
financing because of the increased funding costs that would result. It was unclear
whether Moody’s was serious or if this was simply a threat designed to have
the federal government back off its criticism and attacks on the rating agencies.
If it was the latter, it did not work. The House Financial Services Committee
approved a bill to require credit rating agencies to use different rating measures
for municipal securities and corporate bonds. That committee, as well as some
states, believed that by using the same rating systems, municipal securities were
receiving lower ratings than comparable corporate bonds. In response to that
pressure, Moody’s announced in March 2010 that it was changing its ratings
to use a single scale for municipal and corporate bonds.

Connecticut attorney general Richard Blumenthal, who was about to begin

a campaign for a Senate seat, did not wait for legislation to be enacted. In July
2008 he filed suit against the rating agencies, claiming that they had systemati-
cally and intentionally given lower ratings to states and municipalities than to
corporations and other entities with higher default rates. The rating agencies
entered into an agreement with New York attorney general Andrew Cuomo
on June 5, 2008, pursuant to which they agreed to strengthen their indepen-
dence and ensure that critical loan data were available before they rated loan
pools. The rating agencies further agreed to increase their transparency in
connection with their ratings for the residential mortgage-backed securities
market. In order to restrict shopping for ratings, the settlement required the
ratings firms to be paid for their reviews, even if they were not hired to rate
the transaction. The theory was that the rating agencies would be less inclined
to provide the desired rating merely in order to get paid. In addition, the rating
agencies agreed to review due diligence reports on loans being securitized and
to establish criteria for assessing the reliability of loan originators.
The SEC also jumped on the rating agencies once again. An SEC staff study
in July 2008 detailed what it called significant flaws in the rating processes
at the larger credit rating agencies. The SEC proposed requiring credit rating
firms to make more disclosures about how they rated securities and to provide
special classifications for securitized instruments. The SEC also proposed
prohibiting rating agencies from rating instruments that they designed, leaving
them little incentive to develop new products, hardly a desirable economic
goal. In addition, executives at rating agencies negotiating fees would be pro-
hibited from involvement in the rating of the company’s securities. Under the
SEC proposals, employees of rating agencies involved in advising on rating
methodologies would be prohibited from receiving a gift of more than $25
per meeting on the issue. More significantly, the rating agencies would have
to publish the performance of their ratings over one-, three-, and ten-year pe-
riods, including upgrades and downgrades. The SEC also proposed changing
its rules to remove some references to NRSROs as value determiners, and it
cautioned investors that a credit rating was only the first step in considering
whether to make an investment.
The SEC decided in December 2008 to defer action on the proposal to
require the rating agencies to differentiate between bonds and structured in-
vestments in their rating methodologies. The agency also deferred action on
its proposal requiring the rating firms to disclose all underlying information
about debt offerings being rated. The SEC adopted some changes that required
the rating agencies to take additional steps to mitigate conflicts of interest, to
require more disclosures of their rating processes, and to disclose the perfor-
mance of their ratings. This did not satisfy rating agency critics, and in July
2009 the Obama administration proposed the creation of a special office in
the SEC to monitor rating agencies and the separation by rating agencies of
ratings of structured finance from those of other debt offerings. Additional

disclosures would also be required. The SEC went a step further in April 2010,
proposing a rule that would remove recognition of the rating agencies as an
official evaluator of mortgage and other asset-backed securities. Instead, the
return on the bonds would have to be vouchsafed by the CEO of the issuer
and the issuer would have to invest its own funds in at least 5 percent of the
issue. This was a radical departure from the view that investors accepted the
risks of an investment and that issuers could not guarantee returns.
The Dodd-Frank Act adopted many of these proposals. The legislation
stated that regulation was justified because the ratings agencies are financial
‘‘gatekeepers’’ and should be subject to the same standards of liability and
oversight as auditors, securities analysts, and investment bankers. The legisla-
tive justification statement also noted that the mis-rating of structured products
had contributed substantially to the subprime crisis. Among other things, rating
agencies were, in a Sarbanes-Oxley-like provision, required by Dodd-Frank to
strengthen their internal controls and attest to their effectiveness. The SEC was
directed to establish an Office of Credit Ratings, and the agency was required
to conduct examinations of credit rating agencies at least once a year.
The SEC was directed to adopt rules governing the procedures and method-
ologies for credit ratings, including qualitative and quantitative data and models,
used by the rating agencies. Where the SEC was to obtain that expertise was left
unsaid. Disclosure of rating methodologies was also required. At least 50 percent
of the board of directors of the rating agencies were required to be independent
directors. The rating agencies were required to become informers on their cli-
ents and to report any violations of the federal securities laws that they might
observe in the course of gathering information for a rating. Ratings analysts will
be required to pass qualifying exams and have continuing education.
The SEC was directed by Dodd-Frank to study whether credit rating agen-
cies should be assigned by an independent body to rate CDOs. The comptrol-
ler general was directed to report on alternatives to the credit rating agencies,
including the creation of an independent professional analyst organization.
Jules B. Kroll, the founder of the investigative firm Kroll Associates, which
he had sold before it tanked to Marsh & McLennan in 2004, announced the
formation of a new rating agency in August 2009. That business would charge
subscription fees for information and services. Another commonsense approach
might be to fix the risk models. Obviously, models cannot account for every
unexpected risk, but stress-testing could be improved.
Dodd-Frank also requires that all statutory or regulatory references to credit
ratings by NRSROs be replaced by the term “meets the standards for credit-
worthiness as established by [the relevant federal regulator.]” A last-minute
change in the Dodd-Frank legislation also made the ratings agencies liable for
the quality of their ratings under the Securities Act of 1933. This caused all
three of the rating agencies to suspend the use of their ratings for asset-backed
bonds, which then had the effect of freezing that $1.2 trillion dollar market.
Among those frozen out of the market was Ford Motor Company’s financing

arm. The SEC then acted to allow bond offerings to be made without credit
ratings for a period of six months.
More than thirty lawsuits were filed against the rating agencies claiming
damage as the result of their faulty ratings. These cases were defended on
that ground that the rating agencies were merely expressing an opinion on
the creditworthiness of a company or instrument and that this was protected
speech under the First Amendment to the Constitution. A federal judge ruled
in one case that the rating agencies were not protected by the First Amendment
where their ratings report went only to a select group of investors. In an earlier
case, the Supreme Court held that a credit report issued by Dun & Bradstreet,
which mistakenly reported that a private company was in bankruptcy, was not
protected by the First Amendment privileges available to newspapers.64
One class-action lawsuit charged that Moody’s had falsely claimed that it
was an independent body in issuing its ratings. A federal district court held
that the complaint stated a cause of action because it charged that ratings were
changed by Moody’s at the request of issuers and that Moody’s had falsely
described its ratings methodologies. The California Public Employees Retire-
ment System (CalPERS) sought to cut its $1 billion in losses from structured
subprime products by suing the rating agencies. The lawsuit claimed that the
rating agencies had made negligent misrepresentations to CalPERS by rating
those instruments as triple-A. CalPERS claimed that the rating agencies had
acted incompetently in issuing the ratings and in assessing the credit risks
associated with those instruments. CalPERS was given more reason to be
angry with the rating agencies after this lawsuit was filed. In December 2009,
Moody’s downgraded its rating to Aa3.
The National Association of Insurance Commissioners (NAIC), an orga-
nization of state insurance regulators, announced in October 2008 that it was
considering entering the credit ratings business. NAIC already reviewed credit
quality and rating securities owned by state-regulated insurance companies as
reserve investments. That effort was given a boost in September 2009, when
a whistle-blower, Eric Kolchinsky, a former analyst at Moody’s, charged that
Moody’s continued to give inflated ratings to structured securities in 2009.
Scott McCleskey, the former head of compliance at Moody’s, also claimed
that it did not properly monitor the ratings that it gave municipal bonds, and
he, and other compliance officers, had been replaced by structured finance
analysts who rated the securities that had to be later downgraded.
State insurance commissioners used that scandal to attack the rating agencies
again and to try to remove rating agencies as the arbiters of investment risks
embedded in insurance company portfolios. Replacing them with government
ratings, however, is a prescription for disaster. Politics, not economics, will surely
control such ratings. This also raises the question of how can a risk-modeling
program be regulated without making the government itself a rating agency?
The danger of having the government dictate risk management models is
apparent. They can use that power to manage the form of business models.

When it came into office in 2009, the Obama administration stress-tested the
largest nineteen banks to determine their viability. The stress tests sought to
determine whether the banks could survive a 3.3 percent contraction in the
economy in 2009 and flat growth in 2010. This stress-testing assumed an ad-
ditional 22 percent decline in housing prices and an unemployment rate that
would rise over the next two years to 10.3 percent. Banks that had problems
surviving under these scenarios were given six months to raise capital privately.
Failing that, the government would buy convertible preferred shares from the
banks that would pay a 9 percent dividend and would convert to common stock.
This effort was the first step in broadening risk models to test for the effects
of catastrophic risks. That was commendable, but it became associated with
nationalization of the financial services industry as well, because regulators
were using its stress test as leverage to manage the banks’ balance sheets.
Consumer Protection
The Fed was directed by the Dodd-Frank Act to adopt regulations prohibiting
lenders from making a residential mortgage loan unless the creditor makes a
reasonable and good faith determination based on verified and documented
information that, at the time the loan is consummated, the consumer has a
reasonable ability to repay the loan, according to its terms, and all applicable
taxes, insurance (including mortgage guarantee insurance), and assessments.
That determination is to be based upon consideration of the consumer’s credit
history, current income, expected income the consumer is reasonably assured
of receiving, current obligations, debt-to-income ratio or the residual income
the consumer will have after paying non-mortgage debt and mortgage-related
obligations, employment status, and other financial resources other than the
consumer’s equity in the dwelling or real property that secures repayment of
the loan. A creditor shall determine the ability of the consumer to repay using
a payment schedule that fully amortizes the loan over the term of the loan. Liar
loans are prohibited—the lender must verify the borrower’s income.
More consumer protection was added in the form of electric utility rate
regulation. The Fed was directed to adopt rules regulating interchange fees
for processing debit card transactions, which are required to be reasonable and
proportional in relation to their expense to the issuer. The Fed was also autho-
rized to regulate network fees charged for processing credit card transactions.
Restrictions on access to networks by card companies were also attacked. In
anticipation of these restrictions, many banks were raising other fees and plan-
ning to pass on to consumers other costs of the Dodd-Frank legislation and the
Credit Card Accountability, Responsibility and Disclosure Act that was passed
in 2009 (it restricted the ability of banks to increase rates). The average interest
rate being charged on credit cards climbed to 14.7 percent. Other consumer
protection in the Dodd-Frank legislation included disclosures on remittances,
which are popular for recent immigrants sending money home to families.

Additional regulation was imposed on mortgage originators who were

required to be registered or licensed, and a number of predatory practices
were prohibited. Those practices include steering consumers to a residential
mortgage for which they lack a reasonable basis to pay or which utilizes
equity stripping (loans made to remove the equity built up in a home),
imposes excess fees or has other abusive terms. If a mortgage originator is
unable to provide a loan that a consumer qualifies for, the originator must
discourage the consumer from seeking a mortgage from another mortgage
originator. This adds a bit of paternalism to the application process. Falsi-
fying borrowers’ credit history and property appraisals is prohibited, and
origination fees and yield-spread premiums paid as origination fees to
mortgage brokers are restricted. Prepayment penalties are limited when
mortgages are paid off early and restrictions were placed on loans with
negative amortization, and special disclosures are required for loans that
reset interest rates after an introductory period. Property appraisers are
required to be independent.
Consumer Financial Protection Bureau
The reforms sought by Treasury Secretary Geithner included a proposal for the
creation of a Consumer Financial Protection Agency, an option that had been
advocated by Harvard Law School professor Elizabeth Warren. As originally
proposed, this agency would have vetted and overseen consumer credit items
such as credit cards, mortgages, savings and banking accounts, and annuities. It
would have required standardized financial products to be sold to retail inves-
tors, for which a safe harbor from litigation claims over their structure would
be created. Non-standardized products would have been subject to litigation,
which would mean that innovation in finance would be stifled.
This proposal ran into opposition from Fed chairman Bernanke, the FDIC,
and the SEC, as well as the business community.65 Representative Barney Frank
watered down the administration’s proposed consumer financial protection
agency’s powers in order to overcome industry resistance. Among other things,
he removed the proposal to require financial services providers to offer certain
plain-vanilla products, like fixed-rate mortgages. Moreover, financial services
firms would not be required to determine whether consumers understood the
products they are purchasing.
The Dodd-Frank Act created the Consumer Financial Protection Bureau
(CFPB) in the Fed headed by an independent director appointed by the presi-
dent and confirmed by the Senate, touching off a fight over whether Professor
Warren should head the new bureau. Since Senate confirmation was unlikely,
she was appointed special advisor leading the creation of the bureau. The
CFPB is tasked with implementing and enforcing federal consumer financial
laws consistently for the purpose of ensuring that all consumers have access
to markets for consumer financial products and services and that markets for

such products and services are fair, transparent, and competitive. The bureau
was given a $500 million budget to carry out that task.
The CFPB will regulate the offering and provision of consumer financial
products or services under the existing federal consumer financial laws. It has
independent authority to write rules governing consumer protection for custom-
ers of all financial institutions that offer consumer financial services or products.
However, it must consult with other regulators before a proposal is issued, and
regulators may appeal regulations they believe would put the safety and sound-
ness of the banking system or the stability of the financial system at risk.
The CFPB was given authority to examine and enforce regulations for
banks and credit unions with assets of over $10 billion and all mortgage-
related businesses (including lenders, servicers and mortgage brokers), payday
lenders, student lenders (who will be overseen by a Private Education Loan
Ombudsman), debt collectors, and consumer reporting agencies. The CFPB
will also oversee enforcement of laws requiring nondiscriminatory access to
credit for individuals and communities. Certain powers of the Federal Trade
Commission were transferred to the CFPB but the two agencies were allowed
to enforce each other’s rules.
The CFPB was given the power to subpoena witnesses and to issue civil
investigative demands for documents, and those demands are enforceable
in court. The CFPB may issue a notice of charges upon the discovery of a
violation and, after an opportunity for a hearing, issue a cease and desist or
corrective action order and impose civil penalties or order equitable relief, all
of which are subject to judicial review. The bureau may also make criminal
referrals to the Justice Department.
State laws inconsistent with CFPB rules are preempted, except that state
laws offering greater protection than CFPB are deemed not inconsistent. CFPB
will thus set the floor on consumer protection provisions at the state and federal
level. There are a large number of exclusions from CFPB regulation, including
auto dealers not providing non-assignable loans and other small businesses,
persons, and entities regulated by the SEC and CFTC. The bureau is also pro-
hibited from establishing usury limits on loans. However, “high cost” residential
mortgages (generally those with interest rates over 6.5 points higher than the
prime rate for a comparable transaction) are subject to regulation.
The legislation created a new Office of Financial Education in the CFPB
that is to develop and implement a strategy to improve the financial literacy
of consumers in consultation with the Financial Literacy and Education Com-
mission and consistent with the National Strategy for Financial Education. The
bureau was directed to conduct a number of studies, including one on reverse
mortgages in order to identify any improper activity and to prescribe disclo-
sures, another on student loans, and still another on credit scores. A separate
study was ordered to be prepared by the HUD secretary for shared appreciation
mortgages in which the lender shares in equity appreciation of the home at the
time of its sale in exchange for reduced or no interest payments.

Compensation Issues Again
The compensation of executives at Enron and other firms caught up in the

scandals of that era caused much outrage. The subprime crisis had an even
greater effect after it was revealed that executives at financial services firms
that failed had collectively received tens of billions of dollars in compensa-
tion. Labor unions renewed their attacks on executive compensation during
the subprime crisis, with proposals that would curb executive pay at large
institutions that received bailout funds in the TARP.66 That concern was ad-
dressed in the stimulus package passed by Congress in February 2009, which
contained some severe limitations on the pay of the top executives at firms
receiving bailout funds. Reformers were not satisfied, and they sought legisla-
tion that would extend this requirement to all public companies. The result was
predictable. Talented executives at large Wall Street financial services firms
left their employment at firms receiving bailout money in droves for smaller
private firms that were not subject to salary caps or government harassment.67
A study by Kenneth Feinberg, the Obama administration’s “special master
for TARP executive compensation,” more commonly referred to as the “pay
czar,” concluded that some 15 percent of senior executives had left firms that
were subject to TARP pay restrictions.
President Obama announced a proposal for a bonus tax in the United States
that would be used to pay for TARP costs. The president, who reported an ad-
justed gross income of $5.5 million in 2009, continued his populist themes with
a statement on January 14, 2010, that labeled forthcoming bonuses at financial
services firms as obscene. The financial services firms were, indeed, preparing
to pay out record bonuses for 2009, even exceeding 2007 levels, so they made
good targets for these populist attacks. Bonuses on Wall Street increased by
17 percent in 2009 over the prior year. Overall compensation for Wall Street
employees reached a record $140 billion that year. Only the most senior execu-
tives were taking pay cuts in order to avoid unfavorable publicity.
Executives outside Wall Street were not so shy. The winner in excessive
compensation for the decade was Larry Ellison at the Oracle Corp. He received
$1.84 billion during that period. Barry Diller was the runner-up with $1.14
billion. No one objected after Forbes reported that Oprah Winfrey made $315
million in 2009, that movie director James Cameron made $210 million, that
Beyonce made $87 million, and Lady Gaga scored $62 million. The New
York Times did criticize Ellen V. Futter, the head of the American Museum of
Natural History, for being paid $877,000 in 2010 while being housed in a $5
million apartment tax free. Glenn Lowry, director of the Museum of Modern
Art was reported to have been paid $2 million and was living in the museum’s
$6 million condominium.
In the event, the Fed imposed permanent controls over bank employee com-
pensation in June 2010 that were designed to assure that banks were not providing
incentives for employees to incur undue risks. How the Fed could make such

determinations was unclear. The Dodd-Frank Act also gave corporate governance
advocates a victory. Despite the need for risk taking in business, regulators were
required to adopt rules prohibiting compensation practices in the form of exces-
sive compensation that encourage excessive risk taking. Dodd-Frank contained
a dream list of other reforms. Shareholders in public companies must now be
given a say on executive pay in the form of the right to a nonbinding vote on
executive pay and golden parachutes. The SEC, however, had already opened
the door to such proposals, few of which succeeded.
The SEC was given authority to allow shareholders proxy access to nomi-
nate directors. This was a requirement that labor unions had long sought as
a way of challenging management. Compensation committees were required
to include only independent directors who would have authority to hire com-
pensation consultants in order to strengthen their independence. However,
those consultants have, in the past, been used only to find innovative ways
to increase pay. Dodd-Frank requires that the ratio of the CEO’s pay to that
of the average worker must be disclosed. Public companies will be required
to disclose why they have or have not decided to split the role of chairman
and CEO. This is another corporate reform that has not been shown to have
had any efficacy. Broker voting restrictions on board votes were adopted by
Dodd-Frank, a reform already embraced by the SEC. Public companies are
now required to adopt claw back provisions for executive compensation that
was paid on the basis of inaccurate financial information.
The newest reform mantra is to prohibit compensation programs that provide
incentives for executives to engage in undue or excessive risks. In October
2009, Kenneth Feinberg ordered the salaries of 175 of the highest-paid execu-
tives at firms receiving TARP funds to be cut an average of 50 percent. Fed
chairman Bernanke at the same time announced that the Fed would adopt rules
requiring the largest twenty-eight financial firms to justify their compensation
programs and prove that they do not encourage excessive risk taking. However,
in November 2009 Citigroup announced large option grants to its employees as
bonuses. The following month, Feinberg announced rules limiting the salaries
of the most highly compensated executives at firms receiving TARP funds to
$500,000 and restricting cash bonuses to 45 percent of pay. This pushed the
executives toward stock bonuses, which might signal a return to the Enron era
of accounting manipulations in order to boost stock prices.
The irony here is that it was the Super Senior tranches of the subprime
CDOs that triggered and sustained the crisis. Those tranches were triple-A
rated, the highest rating available for a debt instrument, which meant they
should have had little risk exposure. The banks often eschewed investment in
lower tranches even though they had an investment-grade AA rating and paid
a much higher coupon. The banks did not want even a small increase in the
risks that they were willing to assume. AIG also wrote its CDSs on the triple-A
tranches of the CDOs, which it believed presented it with little or no risk. This
was incorrect because the market collapsed, not because they wanted to take

on excessive risk. On the contrary, they thought of themselves as extremely

conservative investors. The government had taken the same view when it gave
the Super Seniors favorable capital treatment, thereby encouraging the banks
to invest in those instruments.
The incentive system is a critical factor in recruiting and retaining talented
executives. It may also be of concern in managing risks associated with
management decisions, the rogue trader being a prime example. If a trader’s
compensation package is based purely on profits from trading, the trader is
in an enviable position. He has the vast resources of his institution to use to
incur risks that will maximize his bonus, if he is successful. If he is unsuccess-
ful, his compensation is reduced, or he may lose his job. Those same adverse
consequences would attach, however, if he were unsuccessful and did not
incur great risk. For a risk-taker, this is a most desirable position, especially
if he is playing with other people’s money. It is a “heads I win, tails you lose”
proposition.
Ideally, traders and executives should have an incentive arrangement that
rewards those who are concerned with the long-term safety of the firm, as well
as those who earn short-term trading profits. That is not an easy package to
formulate. A possible alternative is to give the trader or executive a “capital”
account at the firm, a proposal that reformers advocate. A significant portion
of the executive’s bonus would be placed in the account each year. The ac-
count, which should pay above market return rates, could not be tapped until
a few years after the trader left the firm or for some delayed period during
which he remains with the firm. This would motivate traders and executives
to take a longer-range profit-maximizing approach. They would be effectively
building a retirement account, not a lifestyle that would require annual trading
binges to finance.
Such compensation schemes would be a sound way to manage risk-related
compensation. Of course, the doctrine of unintended consequences must also
be considered. Executives given options and stock in lieu of cash during the
subprime crisis reaped a windfall after the stock market recovered in the fourth
quarter of 2009. That did not mean that these executives will remain wealthy
because markets go down as well as up as it did in 2010. In any event, despite
all the efforts of the reformers, compensation at Wall Street firms rose by 17
percent in 2009.
Escrowing bonuses also does not assure success. Lehman Brothers had a
five-year vesting period for shares given as bonuses. Moreover, this is still a
matter of business judgment, and it should not be mandated by the government
or union pension funds, which will only try to curb risk. No business can suc-
ceed without incurring risk. Nearly all successful businesses achieved success
by incurring great risk. As the saying goes, no risk, no reward. Ironically, in
the wake of the subprime crisis, some state pension funds, like Wisconsin,
were taking on more risk by leveraging their portfolios in order to increase
returns and make up for losses and shortfalls in funding. At the same time

reformers were seeking to reduce risk taking by the banks by deleveraging

their balance sheets.
Public companies that avoid risk will attract bureaucrats, not fearless lead-
ers, as their executives. Failure in business because of excessive risk taking
(among other reasons) is normal—indeed, desirable. Moreover, risk taking is
necessary for the advancement of society. “No guts, no glory” is a principle
well known to every businessperson. Now, however, government and corporate
reformers are preaching risk avoidance, a way of thinking that is detrimental
to society as a whole. For example, if risk is to be avoided, pharmaceutical
companies must immediately give up their quest for a cure for cancer because
it is not likely to be discovered. The quest for new inventions must also cease
because most inventors fail. The same is true of most new businesses.
A further concern with respect to executive compensation arose after the
stock market declined in the third quarter of 2008. Many executives were
forced to sell their company shares because of margin calls, which exposed
an interesting phenomenon in public companies. Executives are expected
to hold large amounts of the stock of the company that they manage—it’s a
macho thing as well as a loyalty test. However, the executives want cash for
spending and investment outside their company, so they borrow by margin-
ing their company stock, which exposes the executive to margin calls if the
stock declines.
The executive is under even more intense internal and external pressure not
to sell company stock in a decline. Such sales must be reported to the SEC
and made public, and the SEC and criminal prosecutors will wonder whether
the sales were made on the basis of inside information. The alternatives for
the executive are to accept a loss of his fortune by doing nothing or to try to
stop the slide in the stock price by talking up the company and reassuring the
public that all is well, even if it is not or to manipulate company accounts in
order to bolster the stock.
This concentration of stock in a single company violates a fundamental
principle of modern portfolio theory: diversification of investments. The current
macho stockholding view needs to be changed, perhaps by putting deferred
bonuses into a more diversified investment or by encouraging executives to
hedge a substantial portion of their company holdings. This might remove
some of the pressure to take desperate measures in a market downturn that
might mislead investors. Keeping a cool head for management in a crisis re-
quires objectivity. An executive facing the loss of his fortune is not objective;
instead, he is desperate.
Federal Insurance
The Treasury Blueprint that was published in March 2008 had sought to pro-
vide for a federal presence in insurance regulation, including the creation of
an Office of National Insurance and optional federal charters that would allow

insurance companies to be regulated at the federal level. Dodd-Frank did not

provide for optional federal insurance charters, but it placed the federal gov-
ernment into the regulation of the insurance industry, which had previously
been the sole domain of the states as a result of the passage of the McCarran-
Ferguson Act of 1945.
Dodd-Frank created a new Federal Insurance Office (FIO) in the Treasury
Department. The FIO is directed to monitor all aspects of the insurance industry
and to identify any issues that could pose a systemic risk to the industry or to
the financial system as a whole. The FIO may recommend that the Financial
Stability Oversight Council designate an insurance company for regulation
as a non-bank financial company. Dodd-Frank also requires the FIO to moni-
tor whether the poor have access to affordable insurance. Excluded from the
jurisdiction of the FIO are health care insurance, certain long-term care insur-
ance, and crop insurance.
The FIO may preempt state laws that discriminate against foreign insurance
companies, but substantive state insurance regulation is otherwise preserved.
No state other than the home state of an insured may require any premium
tax payment for commercial purchasers of non-admitted insurance, that is,
insurance sold by an insurance company domiciled outside the state of sale.
Such non-admitted insurers are subject to home state regulation only, and
surplus lines brokers are subject to home state only regulation under certain
circumstances. Limitations were also placed on the state’s ability to regulate
reinsurance from other jurisdictions.
Regulation Abroad
The Financial Services Authority
Before the subprime crisis, the Financial Services Authority (FSA), Great
Britain’s single regulator, was a model for regulation around the world. It lost
that respect after the bank run on Northern Rock, the first run on a bank in
England in more than a hundred years, which was blamed on lax regulation.
The bailouts of the Royal Bank of Scotland and Lloyds were also viewed to
be regulatory failures by the FSA. Nevertheless, the UK government began
seeking to increase the FSA’s regulatory powers and costs. Lord Turner of
Ecchinswell, chairman of the FSA, filed a lengthy report recommending that
the agency abandon its “light-touch” approach to regulation, which it did.
The FSA set out to prove its new toughness with the announcement that it
was imposing a record $4.06 million fine on Barclays Bank PLC for its failure
to provide accurate transaction reports on 57.5 million transactions. That situ-
ation sounded like it was most likely the result of a computer glitch, but that
was immaterial to the FSA. In another action, the FSA fined an individual a
record $1.5 million for insider trading. It also banned a Merrill Lynch trader
from the securities business for mismarking his trading book by $100 million.

A larger fine of $40 million was levied against JPMorgan Chase for failing to
properly segregate customer assets. The FSA fined Goldman Sachs $31 mil-
lion for failing to advise the FSA that Fabrice Tourre was under investigation
by the SEC when he moved to London. Tourre remains a defendant in the
ABACUS 2007-ACI SEC case described above.
Lord Turner wanted to increase capital and liquidity requirements for banks
in order to restrict their ability to take excessive risks. Turner also supported
calls for the creation of a pan-European regulatory body, a recommendation
that the FSA had previously opposed. In addition, Turner approved of plans
to curb excess executive compensation schemes at financial institutions
regulated by the FSA. Those points were debatable, but in an interview
Lord Turner strangely advocated that London give up its status as a world
financial center because it was “bloated.” He contended that the financial
services industry there was too big and should be curbed. Even odder was
his suggestion that London adopt a form of “Tobin tax” (named after a plan
by the Nobel Prize–winning economist James Tobin to tax financial services
transactions). Such a tax would be used to support projects in less-developed
countries.
Prime Minister Brown advocated such a Tobin tax at the Group of Twenty
meeting in Scotland in November 2009, but met stiff resistance from the United
States. Brown retreated from the proposal for a time. He turned to advocating a
universal bank tax after the Obama administration announced a plan to impose
$90 billion in new taxes on banks to repay TARP losses. Brown claimed in
February 2010 that there was worldwide support for such a tax. He was then
under attack from his own finance minister, Alistair Darling, who claimed that
Brown had directed the “forces of hell” against him for being too pessimistic
on the economy. Mervyn King, the governor of the Bank of England, made
a recommendation that large banks be required to split up into smaller units
because large financial firms would surely find areas in which to encounter
systemic risk. Brown rejected downgrading financial services in London but
sought to limit bankers’ pay by tying it to long-term success and providing
for clawbacks when losses later occurred. Brown also wanted higher capital
requirements for banks.
On December 9, 2009, the British government announced a 50 percent sur-
charge on banker bonuses of more than $40,700. This led to howls of outrage
in the City of London. Even the New York Times thought this was a bad idea,
but France announced the following day that it too would tax bankers’ bonuses
on the same terms. Germany declined to follow suit, but Chancellor Angela
Merkel thought that curbing bonuses was politically a good idea. Jean-Claude
Trichet, the president of the European Central Bank, joined this chorus and
criticized the bonus culture at financial services firms. In the event, the British
banks simply grossed up the salaries of their executives to cover the tax, and
bonuses were not reduced, so, as usual, shareholders bore the cost.
The Conservative Party in the UK responded with a proposal to abolish the

FSA and to move its powers back to the Bank of England. The Conservatives
also sought a new consumer protection agency, as well as a tax on banks to
repay bailout expenses. The Conservatives were particularly critical of Bob
Diamond, the head of Barclays Capital. He had safely steered Barclays through
the subprime crisis but was criticized for the $100 million in compensation he
had received. Undeterred, Barclays promoted Diamond to become CEO for
the entire bank in September 2010. Hector Sants, the FSA CEO, was wielding
a veto over the hiring of bank executives who did not have sufficiently strong
ethical standards.
The Conservative party was unable to obtain a majority in the May 2010
elections but was able to form a government coalition. They then announced
plans to split the FSA into three new agencies and give the Bank of England
overall leadership in dealing with systemic risk and in regulating large finan-
cial institutions.
Professor Adam C. Pritchard at the University of Michigan Law School
predicted that the regulatory uncertainty, which had pushed financial services
to flee New York for London, was now present in London and would result
in another migration to a more business-friendly venue.68 Friendlier business
climates were becoming harder to find. In Germany, the finance minister pro-
posed a global tax on financial transactions in order to end “binge drinking”
in risky financial services.69 He was supported in that claim by a BIS study
that concluded that because the big banks posed a systemic threat, they should
pay higher taxes.
European Union
The European Union (EU) increasingly adopted a U.S.-style regulatory system

that included antitrust prosecutions even more aggressive than those in the
United States, a zeal that the Obama administration promised to match with
the appointment of trust buster Christine Varney as head of the antitrust divi-
sion in the Justice Department. The EU famously rejected a merger between
General Electric and Honeywell in 2001 that had been approved by the U.S.
Justice Department. The European Commission also imposed a record $1.3
billion fine against Microsoft in May 2008 because the company had failed
to comply with earlier orders concerning its business practices that the EU
found anticompetitive. The commission also opened additional investigations
of Microsoft.
The European Commission fined Intel $1.45 billion for antitrust violations.
An EU ombudsman found that competition authorities had committed “mal-
administration” in pursuing that case against Intel by withholding exculpatory
information. That did not bother those authorities, who on the day following
that report charged Standard & Poor’s with monopoly violations. The EU
was fast becoming a world court for antitrust claims in the tech sector. EU
competition authorities became increasingly aggressive, particularly against

American companies. Those officials staged dramatic Eliot Ness–style raids

on the offices of pharmaceutical companies in 2008. GlaxoSmithKline was
targeted for refusing to sell to Greek drug wholesalers. The refusal actually
came from the Greek wholesalers, who did not want to pay prices as high as
those paid by other Europeans.
The EU also gradually expanded its regulation over financial services.
Although the Sarbanes-Oxley legislation was a failure, the EU adopted a mini-
version of it in May 2006. The EU version imposed responsibility on board
members for financial statements and required them to adopt corporate gov-
ernance codes. Auditors were also regulated, and independence requirements
were imposed on board members. Interestingly, the Obama administration
clashed with European leaders at Group of Twenty meetings over which actions
were needed to deal with the ongoing global financial crisis. President Obama
advocated increased spending as the means to restart economies, while some
of his European counterparts wanted to concentrate on regulatory reform.
In September 2009, the Group of Twenty also had difficulty agreeing on
increased capital requirements for banks. France resisted a proposal by the
United States and the UK to increase such requirements significantly, but
those differences were later resolved. The Financial Stability Board, a group
of regulators appointed by the Group of Twenty to design a more reliable
financial system, recommended limits on bank employee bonuses until the
banks increased their capital. The EU also proposed legislation that would
require between 40 to 60 percent of bank bonuses to be deferred for three to
five years and that 50 percent of the bonus paid out in the first year be in the
form of company stock. This approach seemed short-sighted because it will
encourage executives to inflate the bank’s share price through accounting
manipulation, which was what occurred in America.
Regulators around the world also pushed large banks to develop “living
wills” that would set forth a plan for their liquidation in a crisis, which was not
a bad idea, and was included in the Dodd-Frank Act. The European Shadow
Financial Regulatory Committee, a group of academics and former regulators,
urged the Group of Twenty to require banks to build up their reserves to levels
high enough to withstand future financial crises, regardless of the amount.
The EU announced a plan to create three pan-European regulatory bodies
to enforce common rules for banking, securities, and insurance. They would
strengthen existing EU coordinating bodies for financial services. However,
concerns were raised over whether these regulators would interfere in the fiscal
affairs of the individual member states. The proposed legislation would also
create a European Systemic Risk Board, composed of central bank governors
from the twenty-seven EU member states. A new European System of Financial
Supervisors would be created to regulate particular banks. Those proposals
were agreed to in September 2010.

Conclusion
The United States is at a turning point in its history. We looked into the abyss
during the subprime crisis, and the view was frightening. Many of our leading
financial institutions collapsed or had to be bailed out by the federal govern-
ment. The Great Panic that followed the failure of Lehman Brothers pushed
the world’s financial system perilously close to a breakdown and was saved
only by desperate measures from the Federal Reserve and the Treasury De-
partment. The administration of Barack Obama passed massive legislation as
a corrective measure that intrudes into nearly every corner of finance. Sadly,
it is unlikely that this legislation will do anything more than add unneeded
costs to financial services. It certainly does nothing that will prevent future
financial crises; it is more likely that these reforms, many of which have long
been promoted by corporate activists, will only exacerbate future crises, but
Congress seems heedless of such concerns.
In the final analysis, it must be recognized that regulation cannot stop busi-
ness cycles. The financial system will rebuild itself and begin another cycle of
prosperity. That period of prosperity will inevitably lead to another downturn
and to another crisis, as has occurred throughout history. The cyclical nature
of finance is a lesson that history has taught time and time again. The succes-
sion of bubbles, recessions, downturns, and depressions following periods of
rapid economic growth has been a constant in finance. The government has
long sought to mitigate or avoid these downturns, but those efforts have met
with remarkably little success.
In the present environment, attention will be diverted from the real causes
of the subprime crisis—government policies that not only encouraged but
required massive subprime lending. The banks were then left to twist in the
wind by regulators when the market collapsed by refusing to suspend mark-to-
market accounting. Instead of acknowledging those policy failures, Congress
and regulators have tried to shift blame onto executive compensation schemes.
This is not to suggest that business bears no responsibility for this debacle.
The decline in lending standards must lie squarely on their doorstep.
It is already clear that we have yet to learn that subprime loans are extremely
risky. Despite the catastrophic failures associated with such lending, the Obama
767

768 conclusion
administration proudly announced on September 28, 2009, that it planned to

commit as much as $35 billion in order to finance continued subprime lending.
The Federal Housing Administration (FHA) has continued its policy of low,
but slightly increased, down payments that will allow subprime borrowers
to obtain mortgages that they cannot afford. Fannie Mae and Freddie Mac
continue to dominate the residential mortgage market and continue to pile up
liabilities that the government must now fund.
Although they are failed institutions, Fannie Mae and Freddie Mac pro-
vided approximately 77 percent of the liquidity in the mortgage market in the
second quarter of 2009. Freddie Mac alone purchased or guaranteed $319
billion in mortgage loans and mortgage-related securities in the first half of
2009. Fannie Mae’s book of business reached $3.19 trillion on June 30, 2009,
and it expanded its business despite a second-quarter 2009 loss of $14.8 bil-
lion. Finally, at long last, the new Fannie and Freddie regulator, the Federal
Housing Finance Agency, announced on September 2, 2010, that those entities
will no longer be allowed to buy risky mortgages in order to meet affordable
housing goals.
The Fed also remains rudderless in setting interest rate policy. It has pushed
short-term rates down to nearly zero, setting the stage for the next bubble. The
effects from those low rates are as yet unknown but are probably paving the
way for the next crisis.

Notes
Chapter 9
1. Julian Patterson Forrester, “Fannie Mae/Freddie Mac Uniform Mortgage Instru-

ments.”
2. Charles Morris, The Trillion Dollar Meltdown, p. 41.
3. Barry P. Bosworth et al., The Economics of Federal Credit Programs, p. 57.
4. FDIC, “Breaking New Ground in U.S. Mortgage Lending.”
5. Robert E. Rubin and Jacob Weisberg, In an Uncertain World, Tough Choices from Wall
Street to Washington, p. 258.
6. For a description of an ABCP program, see NationsBank, N.A. v. Commercial Financial
Services, 268 B.R. 579 (N.D. Okla. 2001).
7. In re First Alliance Mortgage Co., 471 F. 3d 977, 984 (9th Cir. 2006).
8. Evan M. Gilreath, “The Entrance of Banks into Subprime Lending.”
9. In re Countrywide Financial Corporation Securities Litigation, 2008 U.S. Dist. LEXIS
102000 (C.D. Cal. 2008).
10. Michael Moss and Geraldine Fabrikant, “Once Trusted Mortgage Pioneers, Now Pa-
riahs,” p. A1.
11. Watters v. Wachovia, 550 U.S. 1 (2007).
12. Jo Becker, Sheryl Gay Stolberg, and Stephan Labaton, “White House Philosophy Stoked
Mortgage Bonfire,” New York Times, December 21, 2008.
13. Gary Fields, “Vermont Mortgage Laws Shut the Door on Bust—and Boom,” Wall Street
Journal, August 17, 2009.
14. Stephen A. Holmes, “Fannie Mae Eases Credit to Aid Mortgage Lending,” New York
Times, September 30, 1999.
15. Gretchen Morgenson, “They Left Fannie Mae, But We Got the Legal Bills,” New York
Times, September 6, 2009.
16. Office of Federal Housing Enterprise Oversight, “Report of Findings to Date from
Special Examination of Fannie Mae.”
17. Paul Weiss Wharton, Rifkind and Garrison, “A Report to the Special Review Committee
of the Board of Directors of Fannie Mae.”
18. Jason T. Strickland, “The Proposed Revelatory Changes to Fannie Mae and Freddie
Mac,” pp. 274–275.
19. Michael Durrer, “Asset-Backed Commercial Paper Conduits.”
20. L. Gordon Crovitz, “When Even Good News Worsens a Panic,” Wall Street Journal,
November 24, 2008.
21. Paul Muolo and Matthew Padilla, Chain of Blame, pp. 28–32.
22. Bosworth et al., The Economics of Federal Credit Programs, p. vii.
23. 12 U.S.C. §1841 (c) (2008).
24. 12 C.F.R. 225.2(a) (1984).
25. Board of Governors of the Federal Reserve System v. Dimension Financial Corp., 474
U.S. 361 (1986).
769

770 Notes to pages 409–496
26. Greg Ip, “The Global Credit Crunch,” Wall Street Journal, October 7, 1998.
27. Gilreath, “The Entrance of Banks into Subprime Lending,” pp. 149, 153–154.
Chapter 10
1. Morris, The Trillion Dollar Meltdown, pp. 133–134.
2. Robert F. Bruner, The Panic of 1907, p. 2.
3. 12 U.S.C. §3901.
4. Ethan S. Harris, Ben Bernanke’s Fed, p. 70.
5. Joshua Cooper Ramo, “The Three Marketeers,” Time, February 15, 1999.
6. Harris, Ben Bernanke’s Fed, p. 71.
7. James Grant, Mr. Market Miscalculates, pp. 129–130.
8. Ibid., p. 132.
9. Daniel McGinn, House Lust.
10. Gillian Tett, Fool’s Gold, p. 122.
11. Adam Michaelson, The Foreclosure of America, p. 213.
12. Roger T. Cole, director, Federal Reserve Division of Banking Supervision and Regula-
tion, “Subprime Mortgage Market,” testimony before the U.S. Senate Committee on Banking,
Housing, and Urban Affairs, March 22, 2007.
13. Harris, Ben Bernanke’s Fed, p. 71.
14. Charles D. Ellis, The Partnership.
15. Ibid., pp. 673–674.
16. De Kwiatkowski v. Bear Stearns & Co., 306 F.3d 1293 (2nd Cir. 2002).
17. Peter Wallison, Fair Value Accounting.
18. Ibid.
19. “Global Shares Hit by Bank Plan Doubt,” Financial Times (London), December 14,
2007.
20. Richard Fletcher, “Forking Out More to the Financial Regulator May Not Be Money
Well Spent,” Daily Telegraph (London), October 18, 2008.
21. Peter Thal Larsen, “Gloves to Come Off as FSA Ends ‘Light Touch’ Era,” Financial
Times (London), March 13, 2009.
22. UBS, Shareholder Report on UBS’s Write-Downs, April 2008, §4.2.2.
23. Tett, Fool’s Gold, pp. 63–64.
24. Freddie Mac, “Freddie Mac Releases Fourth Quarter Financial Results,” February 28,
2008.
25. Douglas McGray, “Checked Cashers Redeemed,” New York Times Magazine, November
9, 2008.
Chapter 11
1. Lawrence G. McDonald and Patrick Robinson, A Colossal Failure of Common Sense,
p. 243.
2. Muolo and Padilla, Chain of Blame, p. 9.
3. Kara Scannell and John R. Emshwiller, “Countrywide Chief Charged with Fraud,” Wall
Street Journal, June 5, 2009.
4. Mike McIntire, “Murky Middleman,” New York Times, April 4, 2009.
5. Amod Choudhary, “Auction Rate Securities = Auction Risky Securities,” Duquesne
Business Law Journal 11 (2008): 24–25.
6. Charles R. Schwab, “Brokers Aren’t Responsible for Bad Bets,” Wall Street Journal,
August 19, 2009.
7. Aimis Art Corp. v. Northern Trust Securities, Inc., Civ. No. 08-8075 (SDNY August 6,
2009).
8. Blount v. Securities and Exchange Commission, 61 F.3d 938 (D.C. Cir. 1995).
9. Vikas Bajaj, “Downturn Tests the Fed’s Ability to Avert a Crisis,” New York Times,
March 9, 2008.
10. William D. Cohan, House of Cards.
11. Kate Kelly, “Inside the Fall of Bear Stearns,” Wall Street Journal, May 9–10, 2009.

Notes to pages 501–586 771
12. Eric Dash and Julie Creswell, “Pays for a Rush to Risk,” New York Times, November
23, 2008.
13. Jenny Anderson, “S.E.C. Unveils Measures to Limit Short Selling,” New York Times,
July 16, 2008.
14. Kara Scannell, “Judge Rules for Pasternak in SEC’s Fraud Case,” Wall Street Journal,
June 13, 2008.
15. Greg Hitt, “Economic Woes Get a Fix,” Wall Street Journal, July 19, 2003.
16. James Grant, “Why No Outrage?” Wall Street Journal, July 19–20, 2008.
17. Grant, Mr. Market Miscalculates, p. 32.
18. Charles Duhigg, “Doubts Raised on Big Backers of Mortgages,” New York Times, May
6, 2008.
Chapter 12
1. Tim Carrington, The Year They Sold Wall Street, pp. 226–227.
2. “Lehman’s First,” Investment Dealers Digest, November 17, 2007.
3. Susanne Craig, Jeffrey McCracken, Aaron Lucchetti, and Kate Kelly, “The Weekend
That Wall Street Died,” Wall Street Journal, December 29, 2008.
4. David Wessel, In Fed We Trust, p. 19.
5. McDonald and Robinson, A Colossal Failure of Common Sense, p. 307.
6. Ibid., p. 14.
7. Steve Stecklow and Diya Gullapalli, “A Money-Fund Manager’s Fateful Shift,” Wall
Street Journal, December 8, 2008.
8. Matthew P. Fink, The Rise of Mutual Funds, p. 39.
9. Ibid., pp. 150–151.
10. John C. Whitehead, “Scary,” Wall Street Journal, December 22, 2005.
11. James Freeman, “Eliot Spitzer and the Decline of AIG,” Wall Street Journal, May 16,
2008.
12. Robert O’Harrow, Jr., and Brady Dennis, “Credit Rating Downgrade,” Los Angeles Times,
January 2, 2009, http://articles.latimes.com/2009/jan/02/business/fi-aig2/.
13. Sudeep Reddy, “Bernanke Expresses Frustration Over AIG Rescue,” Wall Street Journal,
March 4, 2009.
14. Noam Scheiber, “A New Theory of the AIG Catastrophe,” New Republic, April 15,
2009.
15. The author was counsel to Merrill Lynch in that affair and other matters.
16. Carrick Mollenkamp and Serena Ng, “Wall Street Wizardry Amplified Credit Crisis,”
Wall Street Journal, December 27, 2007.
17. Gretchen Morgenson, “How the Thundering Herd Faltered and Failed,” New York Times,
November 9, 2008.
18. Liz Rappaport, “Lewis Says U.S. Ordered Silence on Deal,” Wall Street Journal, April
23, 2009.
19. Susanne Craig, “Merrill’s $10 Million Men,” Wall Street Journal, March 4, 2009.
20. “Traders Group Faults SEC Over Decision on Short Selling Ban,” p. 85.
21. James S. Olson, Saving Capitalism, pp. 16–17.
22. “Give Bank Boards a Spine,” Wall Street Journal, May 27, 2008.
Chapter 13
1. Peter Lattman and Jeffrey McCracken, “Buyout Shops Swoop in for a Feast on the
Cheap,” Wall Street Journal, December 31, 2003.
2. Al Gore and David Blood, “We Need Sustainable Capitalism,” Wall Street Journal,
November 5, 2008.
3. L. Gordon Crovitz, “No Such Thing as Riskless Venture Capital,” Wall Street Journal,
August 10, 2009.
4. Peter S. Goodman, “Taking Hard New Look at a Greenspan Legacy,” New York Times,
October 9, 2008.
5. Fannie Mae, Housing Matters, p. 208.

6. Jim Puzzanghera, “Former Fed Chief ‘Shocked’ by Crisis,” Los Angeles Times, October
24, 2008.
7. Alan Greenspan, “The Fed Didn’t Cause the Housing Bubble,” Wall Street Journal,
March 11, 2009.
8. Eric Lipton and Stephen Labaton, “A Deregulator Looks Back, Unswayed,” New York
Times, November 17, 2008.
9. Phil Gramm, “Deregulation and the Financial Panic,” Wall Street Journal, February
20, 2009.
10. Floyd Norris, “A Month-Long Walk on the Wild Side of the Stock Market,” New York
Times, November 1, 2008.
11. Eric Lipton and Ron Dixon, “With Its Own Ills, Bank Lends Only a Trickle of Bailout
Funds,” New York Times, January 14, 2009.
12. Carter Dougherty, “Sweden’s Fix for Banks,” New York Times, January 23, 2009.
13. Dash and Creswell, “Citigroup Pays for a Rush to Risk,” New York Times, November
23, 2008.
14. Ken Brown and David Enrich, “Rubin, Under Fire, Defends His Role at Citi,” Wall
Street Journal, November 29–30, 2008.
15. Michael J. de la Merced, “Supreme Court Moves to Delay Chrysler’s Sale,” New York
Times, June 9, 2009.
16. Stanley Pignal and Brooke Masters, “UBS Under Fire Over Madoff,” Financial Times
(London), February 26, 2009.
17. Julie Cresswell and Landon Thomas, Jr., “The Talented Mr. Madoff,” New York Times,
January 25, 2009.
18. Becker, Stolberg, and Labaton, “White House Philosophy Stoked Mortgage
Bonfire.”
19. Eric Lichtblau, “Wall St. Fraud Prosecutions Fall Sharply,” New York Times, December
25, 2008.
Chapter 14
1. Seth Niraj, Jackie Range, and Geeta Anand, “Corporate Scandal Shakes India,” Wall
Street Journal, January 8, 2009.
2. Mark Maremount, “Highflying Financier Faces Questions Over Fund Empire,” Wall
Street Journal, April 1, 2009.
3. Charles Duhigg, “Two Fallen Mortgage Giants Are Unlikely to Be Restored,” New York
Times, March 3, 2009.
4. Allen Sykora, “Gold’s Perfect Storm,” Wall Street Journal, February 23, 2009.
5. “Bernanke Repeats Opposition to Outright Nationalization of Banks,” Securities Regula-
tion and Law Report 41 (March 2, 2009).
6. Jonathan Weisman, “Obama Pushes Sweeping Change,” Wall Street Journal, February
27, 2009.
7. Ibid.
8. “Regulatory Reform,” Securities Regulation and Law Report 41 (March 2, 2009).
9. Floyd Norris, “The Deal That Fueled Subprime,” New York Times, March 6, 2009.
10. Maureen Dowd, “Disgorge, Wall Street Fat Cats,” New York Times, February 1, 2009.
11. Ulrike Dauer, “In Europe, Goldman’s Blankfein Assails Pay,” Wall Street Journal,
September 10, 2009.
12. Robert H. Frank, “Should Congress Limit Executive Pay?” New York Times, January
4, 2009.
13. Aaron Lucchetti, “Goldman’s Blankfein Calls for Pay Change,” Wall Street Journal,
April 8, 2008.
14. Jenny Anderson, “New Exotic Investments Emerging on Wall Street,” New York Times,
September 6, 2009.
15. Patrick Jenkins and George Parker, “Bankers Rail Against Proposals in UK Government’s
Walker Review,” Financial Times (London), July 17, 2009.
16. Edmund L. Andrews and Jackie Calmes, “Fed Chairman Tacitly Backs Calls for Spend-
ing,” New York Times, March 4, 2009.

17. David Segal, “Financial Fraud Rises as Target for Prosecutors,” New York Times, March
12, 2009.
18. Edward Luce and Chrystia Freeland, “Summers Backs State Action,” Financial Times
(London), March 9, 2009.
19. Martin Wolf, “Seeds of Its Own Destruction,” Financial Times (London), March 9,
2009.
20. SEC, Revisions to Rules Regulating Money Market Funds, 55 Fed. Reg. 30239 (July
25, 1990).
21. “Secretary of the Fed,” Wall Street Journal, March 20, 2009.
22. Patricia Crisafulli, The House of Dimon, p. 6.
23. Peter S. Goodman, “Late-Fee Profits May Trump Plan to Modify Loans,” New York
Times, July 30, 2009.
24. “Experts on Bernanke Speech,” Business Week, August 21, 2009.
25. Francesco Guerrera and Krishna Guba, “Fed Turns a $14bn Profit on Crisis Loans,”
Financial Times (London), August 31, 2009.
26. Zachery Kouwe, “As Banks Repay Bailout Money, U.S. Sees a Profit,” New York Times,
August 31, 2009.
Chapter 15
1. Kevin Phillips, Bad Money, p. 30.
2. Wessel, In Fed We Trust, p. 272.
3. 12 U.S.C. §§ 2801–2811.
4. McDonald and Robinson, A Colossal Failure of Common Sense, p. 4.
5. Congressional Senate Oversight Committee, Hearings on Regulation of the Financial
Sector, January 14, 2009.
6. Cohan, House of Cards, p. 297.
7. ACORN, www.acorn.org/index.php?id=12342.
Sector, January 14, 2009.
9. Ibid.
10. Randall S. Kroszner, “The Community Reinvestment Act and the Recent Mortgage
Crisis,” address delivered before the Confronting Concentrated Poverty Policy Forum, Washing-
ton, DC, December 3, 2008, www.federalreserve.gov/newsevents/speech/kroszner20081203a.
htm.
11. Gramm, “Deregulation and the Financial Panic.”
12. Roberto Quercia, Michael Stegman, and Walt Davis, “Assessing the Impact of North
Carolina’s Predatory Lending Law,” Housing Policy Debate 15 (2004).
13. Gramm, “Deregulation and the Financial Panic.”
14. Fannie Mae, Housing Matters, p. 6.
15. Ibid., p. 13.
16. Ibid., p. 17.
Sector, January 14, 2009
18. Dick Morris and Eileen McGann, Catastrophe and How to Fight Back, p. 81.
19. Office of the Attorney General of the State of New York, www.oag.state.ny.us/about.
html.
20. Howard Husock, “Housing Goals We Can’t Afford,” New York Times, December 11,
2008.
21. Peter J. Wallison, “Barney Frank, Predatory Lender,” Wall Street Journal, October 16,
2009.
23. Ibid., p. 149.
24. Hal S. Scott, The Global Financial Crisis.
26. Jeffrey Friedman, “Bank Pay and the Financial Crisis,” Wall Street Journal, September
24, 2009.


28. Brian S. Wesbury and Robert Stein, “Mr. President, Suspend Mark-to-Market,” Forbes.
com, January 21, 2009, at http://www.forbes.com/2009/01/20/accounting-treasury-obama-oped-
cx_bw_rs_0121wesburystein.html.
29. Olson, Saving Capitalism, pp. 79–80.
30. Accounting Principles, Securities Regulation & Law Report, Bureau of National Affairs,
Washington, DC, October 27, 1980.
31. Holman W. Jenkins, Jr., “Buffett’s Unmentionable Bank Solution,” Wall Street Journal,
March 11, 2009.
32. Todd Davenport, “Fair Value,” American Banker 173 (March 24, 2008).
33. Susan Pulliam and Tom McGinty, “Congress Helped Banks Defang Key Rule,” Wall
Street Journal, June 3, 2009.
34. Appraisal Institute, The Appraisal of Real Estate, p. 23.
35. Guy Stewart, Discriminating Risk, pp. 47–48.
36. Delaware General Corp. Laws §262 (2008).
37. Bell v. Kirby Lumber Corp. 413 A.2d 137 (Del. 1980).
38. Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983).
39. Vincent Ryan, “Shiller to CFOs: Quick Action Needed to Avert ‘D-Word,’” CFO, March
9, 2009, http://www.cfo.com/article.cfm/13257035/c_13254232?f=todayinfinance_next/.
40. Sam Jones, “Of Couples and Copulas,” Financial Times (London), April 25–26, §2,
p. 2.
41. Nassim Nicholas Taleb, The Black Swan, p. xviii.
42. Robert Shiller, “In Defense of Financial Innovation,” Financial Times (London), Sep-
tember 28, 2009.
43. Deborah Solomon, “Treasury’s Paulson Warns of the Costs of Rules Overlap,” Wall
Street Journal, November 21, 2006.
44. Department of the Treasury, “Blueprint for a Modernized Financial Regulatory Struc-
ture,” March 2008.
45. Ibid., p. 4.
46. Elizabeth Williamson, “Political Pendulum Swings Toward Stricter Regulation,” Wall
Street Journal, March 24, 2008.
47. Eliot Spitzer, “How to Ground the Street,” Washington Post, November 16, 2008.
48. Department of the Treasury, “Financial Regulatory Reform,” June 17, 2009.
49. Andrew Ross Sorkin, “Bringing a Bitter Pill to Wall Street,” New York Times, September
15, 2009.
50. Rubin and Weisberg, In an Uncertain World, p. 294.
51. Damian Paletta, “Single Regulator Plan for Banks Now Close,” Wall Street Journal,
May 28, 2009; Damian Paletta and Kara Scannell, “Financial Overhaul Raises Questions,”
Wall Street Journal, May 29, 2009.
52. Financial Planning Ass’n, v. SEC, 482 F.3d 481 (D.C. Cir. 2007).
53. Stephen Labaton, “An Overhaul of Financial Rules Is Taking Shape,” New York Times,
June 1, 2009, pp. B1, B5.
54. Robert O’Harrow, Jr., and Brady Dennis, “Downgrades and Downfall,” Washington
Post, December 31, 2008, p. A01.
55. Depository Trust & Clearing Corporation (DTCC), DTCC Media Statement on General
Motors Credit Default Swaps, June 4, 2009.
56. “The Meltdown That Wasn’t,” Wall Street Journal, November 15–16, 2008.
57. Securities and Exchange Commission, “Temporary Exemptions for Eligible Credit De-
fault Swaps to Facilitate Operation of Central Counterparties to Clear and Settle Credit Default
Swaps,” 2009 SEC LEXIS 71, January 14, 2009.
58. Lloyd Blankfein, “Do Not Destroy the Essential Catalyst of Risk,” Financial Times
(London), February 9, 2009.
59. Ellis, The Partnership, pp. 98–105.
60. 109 Pub. L. No. 291, 120 Stat. 1327.
61. Ibid.
62. Paul J. Davies, “Half of All CDOs of ABS Failed,” Financial Times (London), Febru-
ary 13, 2009.

63. Ibid.
64. Dun & Bradstreet v. Greenmoss Builders, Inc., 472 U.S. 749 (1985).
65. Stephen Labaton, “Regulators Spar for Turf in Financial Overhaul,” New York Times,
July 25, 2009.
66. Craig Karmin, “Shareholders Renew Push to Regulate Executive Pay,” Wall Street
Journal, February 13, 2009.
67. Graham Bowley and Louise Story, “Crisis Reshaping Wall St. as Stars Begin to Scatter,”
New York Times, April 12, 2009.
68. Adam C. Pritchard, “London as Delaware,” University of Cincinnati Law Review.
69. Bertrand Benoit, “German Minister Calls for Global Tax,” Financial Times (London),
September 12–13, 2009.

Selected Bibliography
A Note on Sources
The Wall Street Journal, the New York Times, and the Financial Times (London) are the principal
sources for market events, statistics, reports and other contemporaneous events described in
text. Numerous government, corporate, and other Web sites also provided a treasure trove of
information. Space prevents citation to the thousands of articles and Web sites used as sources,
but they are readily accessible by searching on LEXIS-NEXIS or Google.com. The follow-
ing selected bibliography contains some of the other sources consulted. I have also drawn on
my previous law review articles in preparing this and the prior volume that are listed in the
bibliography.
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Cumulative Name Index
A.B. Watley, 608 Alabama Lottery Foundation, 49

A.G. Edwards, 558 Alaska Permanent Fund, 277
A.P. Indy, 338 Albertsons, 267
A.R. Baron, 437–438 Alcatel, 39
A.W. Jones, 227 Alcoa, 625
A&P, 56 Aldus Equity, 73
A123 Systems, 674 Alexander Brown and Sons, 253
Aames Financial Corporation, 410 Alexander, Jacob “Kobi,” 111
ABACUS-2007 AC1, 734–735 Alliance Data Systems, 442, 511
Abbot Laboratories, 675 Allianz, 272, 520
ABN Amro, 397, 430 Allison, Herb, 656
Abu Dhabi fund, 267, 277–279 Allstate, 188
Abu Dhabi Investment Authority, 456 Alltel, 276
Abu Dhabi Securities Market, 152 Alpha, 597
ABX index, 407, 746 Alternative Investment Market, 80
ACA Capital Holdings, 405 Althing, 575
ACA Financial Guarantee Corporation, 405 Altman, Sidney, 338
ACA Management LLC (ACA), 734–735 Amalgamated Bank, 123
ACC Capital Holdings (ACCH), 435–436 Amaranth Advisors, 205–207, 209, 211,
Accenture, 7 231
Access International Advisors (AIA Group), Amazon, 66, 70
443, 613 Amazon.com, 253, 667
Ace Cash Express, 468 Ambac Financial Corporation, 403–405,
Ackerman, Don, 112 492, 570, 688
Ackermann, Josef, 683 AMD, 625
Ackman, William, 262 AmerCredit, 410
Adams, Samuel, 283 America Online (AOL), 54, 71
Adelphia Communications, 5–6, 42, 47, 78 American Bankers Association, 719
Advance America, 468 American Banking Association, 161
Affiliated Computer Services, 674 American Bond & Mortgage, 290
Aflac, 119 American Clearing Corporation, 160
Agassi, Andre, 337 American Diversified Savings Bank, 319
Agee, William, 93 American Dream Commitment, 702
Aguirre, Gary, 555 American Enterprise Institute, 239, 399,
AIG Financial Products (AIGFP), 541, 544, 448, 520
638 American Express 129, 247, 474, 524, 585,
Ainsley, P. Steven, 346 654, 658–660, 668–669, 683
Akerson, Daniel, 692 American Federation of Labor-Congress of
Alabama Certificate of Need Board, 49 Industrial Organizations (AFL-CIO),
Alabama Education Foundation, 49 264, 270, 344
785

786 cumulative name index
American Federation of State, County and Arenas, Gilbert, 338

Municipal Employees (AFSCME), 95, Argent Mortgage, 435
120, 500 Argo, Carole, 111
American Home Mortgage Investment Arizona Commercial Lender Mortgages, 614
Corporation, 445 Armstrong, Lance, 337
American Homes Investment Mortgage Armstrong, William W., 185
Corporation, 467 Arnall, Roland, 435
American Institute of Real Estate Arnold, Jerry, 29
Appraisers, 300 Arnold, John, 582
American International Group (AIG), 41, Arthur Andersen, 6–10, 18, 19, 24, 25, 35,
62, 72, 170, 187, 273, 279, 328, 333, 36, 38, 39, 43, 44, 47, 60, 70, 322, 329,
430, 447, 469, 482, 526, 534–546, 433
560–562, 613, 633, 638–640, 642, 647, Ascott Partners, 610
652, 655, 666, 668, 672, 674, 676–678, Ashcroft, John, 201, 333
683–684, 691–692, 710–711, 717, 730, Aspen Institute, 81
733, 738, 743–745 Associates First Capital Corporation, 397
American Mortgage Insurance Company Association of Community Organizations
(AMIC), 546 for Reform Now (ACORN), 699
American Museum of Natural History, 758 Assured Guaranty, 403, 405
American Research and Development ASTA/MAT, 505
(ARD), 251 Astor, John Jacob, 249, 453
American Savings & Loan Association, 318, AT&T Inc., 37, 38, 66, 687, 692
515 Attain System, 147
American Stock Exchange (AMEX), 80, Atticus Capital, 581, 670
144, 148, 149, 152, 153, 155, 158, 160, Aufhauser, David, 488
162, 167 Aurora Loan Services, 411
American Tobacco, 87 Aurora, 213, 214
American Tower, 511 Automatic Data Processing, 146
Americas Wealth Management (AWM), 272 Avago Technologies, 582
AmeriCredit, 692 Avellino, Frank, 612
Ameriquest Mortgage Company, 396, 435 Avery, Kenneth, 47
Amiel, Barbara, 58 Awesome Again, 338
Amos, Daniel P., 119 AXA Group, 272
AMR, 673 AXA SA, 683
Analog Devices, 108 Azerbaijan State Oil, 277
ANB Financial, 503 Azurix, 3, 24, 25
Andersen Worldwide, 35
Anderson, Fred, 109 Babson, Frederick, 722
Angelides, Phil, 696 Babson, Roger, 413
Anglo Irish Bank Corporation, 615–616 Baby Bells, 37–29
Annenberg, Moses, 96 Bache, 546
Annenberg, Walter, 96 Bachmann, John W., 163
Antioco, John F., 103 Bacon, Kevin, 610
Antonucci, Anton, Sr., 666 Bagehot, Walter, 708
AOL, 465 Baikal, 155
AOL Time Warner, 54, 55, 71 Bain Capital, 257, 441–442, 579, 581, 589
Apax Partners, 441 Bain Capital Partners, 530
Apollo Advisors, 258 Bair, Sheila, 265, 505, 587–588, 592, 660,
Apollo Alternative Assets, 578 662, 730, 732
Apollo Global Management, 578, 677 Baker, James A., III, 30, 91
Apollo Management, 443, 578–579 Bally Total Fitness Holdings, 64
Apple Computer, 37, 103, 108, 109, Banc of America Securities, 232, 508
251–252, 692 Banco Bilbao Vizcaya Argentaria, 671
Applix, 34 Banco Santander, 574, 611
Arbor, Patrick, 216 Bancroft family, 347
Archipelago Holdings, 98, 147, 151 Bank de France, 712

cumulative name index 787
Bank for International Settlements (BIS), Barr, Michael S., 676

166, 169, 173, 174, 177, 447, 681, 721, Barr, Wallace, 94
764 Barry, Christopher, 29
Bank Insurance Fund (BIF), 322 Bartiromo, Maria, 114
Bank Medici, 611 Baruch, Hurd, 168
Bank of America (BOA), 35, 56–57, 95, Basel Committee on Banking Supervision,
116, 124–125, 174, 272, 273, 291, 325, 171, 173, 184, 326, 506, 712, 721
389–390, 398–399, 416, 423, 434, 436, Bass brothers, 254
441, 450, 456, 459, 478–480, 489, 500, Bats Exchange Inc., 158
504, 508–509, 513, 528, 545, 548, Baukhage, H.R., 299
550–553, 567–568, 600, 608, 618–619, Bay Area Toll Authority, 492
621, 635, 637, 643, 654, 658–659, 668, Bayly, Daniel, 10–12
673, 682, 686, 688, 702, 704, 729 Bayou Securities, 246
Bank of America Securities, 253, 259 Bayview Financial, 615
Bank of Canada, 461 BB&T, 660, 670
Bank of Credit and Commerce (BCCI), 326 BBC, 614
Bank of East Asia, 575 BCE, 442–443
Bank of England, 429, 451–452, 461, 503, BCGi, 108
513, 566, 572, 628, 644, 648, 655, BDO Seidman, 62
763–764 Beal Bank, 396
Bank of Italy, 291 Bear Stearns, 170, 229, 236, 238, 247, 272,
Bank of Japan, 461, 649 332, 682, 402, 417, 425, 437–440, 446,
Bank of Korea, 575 459, 463, 487, 495–499, 524–526, 528,
Bank of New England Corporation, 325 547, 591, 666, 708, 711, 714, 731
Bank of New York, 391, 412 Bear Stearns High-Grade Structured Credit
Bank of New York Mellon, 172, 174, 464, Enhanced Leveraged Fund, 439
534, 553, 556, 568, 591, 658–660 Bear Stearns High-Grade Structured Credit
Bank of New York Mellon Corp., 492 Fund, 439
Bank of North America, 294 Beattie, Richard, 541
Bank of the United States 95, 453 Beaumont, Ron, 45
Bank of Tokyo-Mitsubishi, 174 Beazer Homes USA, 78, 432, 449, 622
Bank One, 438, 498 Bebe Stores, 620
Bank One Corporation, 498 Beckham, David, 337, 496
Bank USA, 174 Bed Bath & Beyond, 109, 487
Bankers Mutual Fund, 314 Bell & Howell, 268
Bankers Trust, 253 Bell, Alexander Graham, 37, 251
Bankhaus Herstatt, 171 BellSouth, 37
Banking and Securities Industry Committee Bellway, 120
(BASIC), 161 Belnick, Mark, 52
BankUnited, 662 Bendix, 93
Banque AIG, 639 Beneficial Finance, 65, 408, 445
Banque Paribas, 573 Benmosche, Robert, 639, 678, 683–684
Baptist Foundation of Arizona, 7, 8, 329 Bennett, Philip R., 248
Barasch, Spencer, 632 Bent, Bruce R., 313, 531–532
Barbera, Robert, 707 Bent, Bruce, II, 532
Barclays, 34–36, 274, 423, 452, 508, Bentham, Jeremy, 283
528–530, 545, 572–573, 616, 627, 668, Benyo, Christopher, 55
673, 677, 683, 764 Benziger, Stephen J., 544
Barclays Bank, 501, 529, 573, 644 Berger, Michael, 247
Barclays Bank PLC, 762 Berkowitz, Sean, 28, 40
Barclays Capital (BarCap), 145, 645, 764 Berkshire Hathaway, 406, 465, 481, 490,
Barclays Global investors (BGI), 274 502, 537–538, 620, 654, 656, 668
Barings, 475 Berkshire Hathaway Assurance Corporation,
Barker, Randolph H., 500 570
Barofsky, Neil, 647, 657, 677–678 Berle, Adolf, 86, 250
Barone, Ronald, 24 Berliner, Paul S., 510–511

Berman, Ethan, 125 BNC Mortgage, 411, 445, 525

Berman, Gregg, 121 BNP Paribas, 445, 573, 646
Bermingham, David, 16 BNY Institutional Cash Reserves, 534
Bernanke, Ben S., 243, 279, 405, 422, BNY Mellon Capital Markets, 490
425–429, 434, 436, 444–445, 447, 451, Boeing, 66, 95 602, 625
474, 481, 485, 506, 519, 522, 527, 542, Boesky, Ivan, 256
545, 562, 566, 586, 592, 626, 631, 633, Bogle, John, 79
649, 652, 657, 661, 663, 667, 673, 680, Bohan Group, 408
685, 694, 697, 708, 710–711, 730–731, Boies, David, 541
759 Bolten, Joshua, 560
Bershad, David, 132 Bond & Mortgage Guarantee Company,
Bessemer Trust, 251 289, 290
Beta Finance, 456 Bond Market Association, 175
Bethlehem Steel, 87 Bonderman, David, 442
Beverly Hills Savings & Loan, 317 Borders Group, 620
Bevill, Bresler, & Schulman, 319 Borse Dubai, 150
Bextra, 130–131 Boston Options Exchange (BOX), 158, 167
Beyonce, 758 Boston Red Sox, 346
Bhagat, Sanjai, 239 Boston Stock Exchange, 149
BHP Billiton, 694 Bouton, Daniel, 475
Bi-Lo, 56 Bowery Savings Bank, 284
Biggs, John, 79 Boyle, Dan, 10, 13
Bin-Abd-al-Aziz Al Saud, Abdullah, 457 BP, 516–517, 689
Bin-Talal, Al-Waleed, 454, 457, 594 BP America, 61
Birkenfeld, Bradley, 63 Brady Commission, 163, 194, 237, 415
Bischoff, Sir Win, 595 Brady, Nicholas, 194, 415–416
BISYS Group, 134 Braly, Angela, 689
Black, Bernard, 239 Brandeis, Louis D., 100, 184–185
Black, Conrad, 57–59 Brandon, Joseph P., 538
Black, Eli M., 443 Braniff Airlines, 324
Black, Leon, 443 Brant, Ryan, 111
Blackberry, 108 BRASS Utility System, 147
BlackRock, 272, 274, 278, 344, 381, 459, Brazos Higher Education Service
460, 497, 500, 504, 548, 647, 666, 685 Corporation, 389
BlackRock Realty, 685 Breeden, Richard, 44, 57, 333, 446
Blackstone Group, 257, 261, 267–269, 274, Brendsel, Leland, 399–400
278, 442–443, 465, 511, 524, 582, 662, Brennan, David, 216
677 Brent Oil Market, 196–197
Blagojevich, Rod R. 264–265, 348, 600, 651 Brewer, Lynn, 24
Blankfein, Lloyd, 427, 463, 468, 527–528, Bridge Trader, 147
543, 589, 637–638, 643, 676, 683, 688, Bridgepoint Capital, 578
719, 736, 748 Brightpoint, 536
Blitzer, David, 268 Brinkley, Amy Woods, 659
Blockbuster Video, 13, 103, 262 Bristol-Myers-Squibb, 57, 262, 333
Blodget, Henry, 66–67 Broad, Eli, 447
Blogen, 262 Broadband Services, 3, 13–15, 21, 27, 329
Bloomberg, 146, 550 Broadcast.com, 608
Bloomberg Tradebook, 147 Broadcom, 108, 110
Bloomberg, Michael, 82 Brobeck, Phleger & Harrison, 591
Blount Parrish, 491 Brocade Communications Systems, 108,
Blount, William, 491 110–111
Blue Ribbon Commission of Money and Brodsky, David, 70–71
Credit, 310 Broidy, Elliott, 73
Blum, Michael, 548 BrokerTec Futures Exchange (BrokerTec),
Blumenthal, Richard, 509, 752 216
BMW, 662 Brookings Institution, 239, 286

Brooklyn Building and Mutual Loan California Public Employees Retirement

Association, 284 System (CalPERS) 95, 120–122, 124,
Brooks Automation, 108 126, 127, 275, 278, 341–343, 344, 446,
Brown, Gordon, 493, 752, 763 494, 554, 570, 579, 582, 589, 696, 754
Brown, Henry B.R., 313, 531 California State Teachers Retirement System
Brown, James, 10–13 (CalSTRs), 120, 122, 342
Brown, Jerry, 515 Callan, Erin M., 526, 530
Brown, Kevin, 337 Camel, 74
Bruno, Joseph, 73–74 Cameron, James, 758
Brunswick Group, 608 Campbell, Bill, 71
BRUT System, 147 Campeau Corporation, 323
Bryan Cave, 536 Canadian Imperial Bank of Commerce
Buffett, Warren, 34, 82, 115, 256, 348, 406, (CIBC), 34–35, 445, 481, 460
465, 481, 490, 537–538, 570–571, 586, Canary Capital Partners, 231–233, 235, 237
620, 679, 718, 725 Canary, Bill, 50
Buick, 605 Canary, Leura, 50, 51
Build America Bonds, 630 Cantor Financial Futures Exchange (CFFE),
Bulldog Investors, 262 216
Bundesanstalt für Cantor Fitzgerald, 215
Finanzdienstleistungsaufsicht (BaFin), Cape Fear Company, 249
645 Capital One, 94, 106, 445
Bundy, Ted, 612 Capital One Financial Corporation, 463,
Burlington Northern Santa Fe, 679 628, 658, 680
Burlington Northern, 285 Capital Research & Management, 480
Burnham, Daniel P., 65 Capmark, 678
Bush, Barbara, 30 Car Allowance Rebate System (CARS), 606
Bush, George H.W., 30, 91, 270, 320 Carlyle Group, 257, 265–266, 270–271, 275,
Bush, George W., 4, 50, 51, 82, 92, 93, 103, 277, 278, 279, 494 579–580, 607, 662
122, 173, 210, 270, 279, 329, 330, 332, Carnegie Steel, 250, 251
397, 401, 419, 425–428, 435, 447, 451, Carnegie, Andrew, 85, 87
462, 466, 473, 480, 485–486, 492–493, Carney, Cormac J., 110
495, 499, 504, 513, 518, 522, 545, 560, Cash Management Account, 314
563–564, 567–569, 592–593, 603–604, Caspersen, Finn M.W., 65
616, 626, 679, 685, 694, 700, 704–705, Cassano, Joseph J., 541–542
710, 725 Caterpillar, 646, 687, 692
Bush, Neil, 320 Cauley, Gene, 134
Bushnell, David C., 500–501 Causey, Richard “Rick,” 20–21, 23, 25
Business Roundtable Institute for Corporate Cave, Bryan, 333
Ethics, 106 Cavuto, Neil, 52
Butler, Eric, 490 Cayne, James E., 437, 440, 469, 495–497
Butler, Louis, 128 CBS, 569, 635
Byers, Steven, 609 CDX index, 407, 746
Byrd, Robert, 736 CEC Entertainment, 108
Cedel International, 165
CA Technologies, 55 Celebrex, 130–131
CA, 55 Celeste, Richard F., 319
Cablevision, 108 Cendant, 53–55
Cabrini-Green, 305 Centauri, 456
Cacchione, Scott, 584 Centaurus Energy, 582
Cadillac, 605 Center for Public Integrity, 396
Cadwalader, Wickersham & Taft, 482 Centerbridge Partners, 442
Caesars Entertainment, 94 Centex, 431, 653
Caisse d’Epargne, 475, 573 CentexCorp, 668
Caldwell, Leslie, 19 Central Bank of Iceland, 574
California Department of Corporations, Central Bank of Kuwait, 576
243 Central Certificate Service (CCS), 161

Central Republic Bank and Trust, 568 Citibank, 454, 456, 637, 698
Central Statistical Board, 299 Citic Securities, 528
Central Trust, 290 Citicorp, 454, 619
Centro Properties, 453 CitiFinancial Credit Company, 397
Centrust Savings Bank, 320 Citigroup, 35, 56–57, 66, 68, 69, 106, 114,
Cerberus Capital Management, 257, 267, 116, 134, 144, 184, 239, 259, 274,
441, 578, 600–601 277–278, 384–385, 390–391, 396–397,
Chakrapani, Ramesh, 267 403–404, 407, 416, 423, 426, 428–430,
Charles Schwab, 489, 677 433–434, 436, 441, 446, 453–457, 479,
Charlow, David, 388–389 480, 482, 487–488, 492, 497–498,
Charter Communications, 36, 128 500–501, 504, 509, 511, 513, 527–528,
Chase Manhattan, 253 416 541, 543, 545, 548, 556, 560, 567–568,
Chase National Bank, 227 571, 581, 584, 593–597, 599, 600, 608,
Check ’n Go, 468 616, 619–620, 625, 627, 629, 633,
Chenault, Kenneth 585, 683 636–637, 639, 640-643, 647, 650, 654,
Cherkasky, Michael G. 535 656, 658-660, 662-663, 666-668, 671,
Chertoff, Michael, 329 677, 680–682, 688–689, 692, 699, 711,
Chesapeake Energy Corporation, 636 717, 729, 733, 741, 759
Chevrolet, 605 Citigroup Diners Club, 505
Chevron, 125, 620 Citizen Black, 58
Chicago Board of Trade (CBOT), 149, 154, Citron, Robert, 459, 547, 749
156–157, 189–190, 213–218, 407 City Bank, 453
Chicago Board Options Exchange (CBOE), City National Securities, 490
144, 156–159, 167, 190, 217, 223, 407 Cityscape Mortgage, 407
Chicago Butter and Egg Board, 190 Claiborne Farms, 338
Chicago Climate Exchange, 158 Claire’s, 443
Chicago Cubs, 348 Clarke, Charles, 16
Chicago Discount Commodity Brokers, 225 Clarke, Vaughn, 399
Chicago Housing Authority, 305 Clayton Holdings, 408
Chicago Mercantile Exchange (CME), 190, Clayton, Dubilier, & Rice, 275
212–215, 217–218, 220–222, 451, 690 Clear Channel Communications, 257, 441
Chicago Open Board of Trade, 189 Clear Lake National Bank, 396
Chicago Stock Exchange, 144, 148 Clearing House Association of the Banks of
Chico’s, 620 Philadelphia, 170
Children’s Investment Fund Management, Clearing House Interbank Payments
263 Systems (CHIPS), 171
Chin, Denny, 6 Clearstream International, 165, 166
China Construction Bank, 659 Clifford Chance, 591
China Development Bank, 278 Clinton, Bill, 92, 122, 127, 273, 329, 339,
China Investment Corporation, 277, 556, 670 384, 400–401, 563, 583, 590, 616,
Christie, Chris, 333 637–638, 697–698, 701–702, 725
Christopher Flowers, 278 Clinton, Hillary, 273, 329, 339, 609
Chrysler, 261, 342, 418, 441, 600–606, 633, CMBX, 407
640, 655, 687 CNET, 108
Chrysler Financial 519, 606 Coehlo, Tony, 320
Chuck E. Cheese, 108 Coffee, Sugar and Cocoa Exchange, 206
Cincinnati Stock Exchange, 148 Cogent Partners, 672
Cioffi, Ralph, 439–440 Cohen, David, 345–346
Circuit City, 588 Cohn, Gary, 463
Cisco Systems, 70, 632, 663 Cole, James, 333, 536–537
Cisneros, Henry, 701–702 Coles, Scott, 614
CIT Group, 388–389, 467, 494, 617, 654, 665 Colgate-Palmolive, 103
Citadel Investment Group, 230, 496, 581, Collateral Management Service, 164
589, 620 Collins & Aikman, 77
Citi Holdings, 619 Collins, Joseph P., 248
Citi Residential Lending, 436 Colonial Bank, 670

Columbia Funds Distributors, 237 Corrigan, Jerry, 744

Columbia Savings & Loan, 318, 319 Corsair Capital, 588
Comcast, 94 Cortez, Joanne, 26
Commercial Capital, 426 Corzine, Jon, 560, 592
Commercial Paper Funding Facility (CPFF), Cosmo, Nicholas, 614–615
709 Coughlin Stoia Geller Rudman & Robbins,
Commerzbank, 520, 668 36, 134
Committee for Economic Development, 310 Coughlin, Tom, 114
Committee for Uniform Security Procedures Coulbeck, Neil, 16
(CUSIP), 161 Coulson, Cromwell, 145
Committee on Capital Markets Regulation Council of Economic Advisors, 422, 425
(CCMR), 80–82 Country Music Awards, 14
Committee on Compensation Practices, 155 Countrywide Financial, 394, 396, 398, 401,
Committee on Interbank Netting Schemes, 424, 433, 446, 476–479, 483, 508–509,
173 514, 521, 559, 617, 633, 636, 647, 702
Committee on Payment and Settlement Countrywide Mortgage Investment, 514
Systems, 166, 173 County of York Employees Retirement Plan,
Committee to Save the World, 417, 732–733 550
Commodity Exchange (Comex), 190, 482 Couric, Katie, 103
Commodity Exchange Authority, 192 Coventree, 460
Commodity Exchange Commission, 192 Cowell, Simon, 337
Commodity Futures Trading Commission Cox, Christopher, 69, 121, 483, 498, 510,
(CFTC), 174, 183, 192–193, 194–200, 566, 612, 726, 744
201, 205, 206–213, 217, 220, 224–225, Craigslist, 345
230, 246–247, 474, 502, 517, 560, 631, Cranston, Alan, 320
728, 730, 737, 741–747, 757 Crawford, Purdy, 460
Community Reinvestment Corporation, 698 Creative Artists Agency, 89
Compaq Computer, 94, 117 Credit Agricole, 501
Computer Associates, 55, 632 Credit Anstalt, 413
Comverse Technology, 111 Crédit Lyonnais, 443
ConAgra Foods, 56 Credit Suisse First Boston (CSFB), 16, 34,
ConAgra Trade Group 474 35–36, 69–71
Conaway, Charles, 59 Credit Suisse, 63, 68, 155, 272, 443, 490,
Conference Board, 465, 643 501, 520, 572, 578, 599, 616, 620, 645,
Conference on Home Building and Home 654, 668, 677, 683
Ownership, 295 Credit Suisse Securities, 484
Conheeney, John, 213 Crest, 165
ConocoPhilips, 625 Criminal Division Public Integrity Section,
Conrad, Kent, 477 333
Conrail, 604 Crittenton, Jarvis, 338
Consolidated Exchange, 140 Crocs, 217
Constable, Francis, 489 CrossFinder, 155
Consumer Federation of America, 719 Crovitz, L. Gordon, 347
Consumer Financial Protection Bureau Crow, Sheryl, 543
(CFPB), 756–757 Crumpler, Hannibal, 48
Continental Illinois National Bank and Cruz, Zoe, 555
Trust, 418, 515, 711 CSK Auto, 78
Continental Illinois National Bank, 324–325 CSX, 263
Cooper, Roy, 398 Cuban, Mark, 608
Copperfield, David, 337 Cunningham, Shirley, Jr., 135
Corcoran, Thomas S., 299 Cuomo, Andrew, 73, 100, 125, 266, 289, 327–
Corinthian Colleges, 108 328, 343, 388–389, 484, 488–490, 508–
Corporate Fraud Task Force 5, 33, 210, 332, 509, 511, 535, 539, 542, 544, 551, 553,
484, 679 563, 565, 607, 611, 613, 636, 638, 640–
Corporate Library, 702 641, 682, 689, 703–704, 733, 746, 752
Corre’s Hotel, 139 Cuomo, Mario, 704

Custer, George Armstrong, 217 Deutsche Börse, 152, 165, 215

Customer Asset Protection Company (CAP), Deutsche Telecom AG, 683
531 Deutsche Terminbörse, 215
CVC Capital Partners, 258 Devaney, John, 580
CVS Caremark, 267 Devlin, Matthew C., 608
Cyberonics, 112 Dewey, Thomas E., 327
Dewing, A.S., 723
D.E. Shaw & Company, 638 Dexia, 573
D.R. Horton, 621 Dexia SA, 492
Daimler, 600 Diamond, Robert E., Jr. “Bob,” 274, 644, 764
Daimler-Benz, 600 Dick, Melvin, 47
DaimlerChrysler, 600 Digital Equipment Company, 251
Dallas Mavericks, 608 Diller, Barry, 758
Damiler AG, 683 Diller, Barry, 103
Darby, Giles, 16 Dillion, C. Douglas, 457
Darling, Alistair, 452, 513, 528, 763 Dillon Read Capital Management (Dillion
Daschle, Tom, 592 Read), 457
Data Domain, 71 Dillon, Clarence, 457
Daugerdas, Paul M., 62 Dimon, James, “Jamie,” 82, 438, 455, 463,
Dauman, Philippe, 337 497–498, 511, 637, 641, 654, 660, 674, 682
Dave & Buster’s, 671 Dinallo, Eric R., 406–407, 535, 538
David, George, 103, 113 DiNapoli, Thomas P., 343
Davies, George, 548 DiPascali, Frank, 612
Davis Selected Advisers, 550 Direct Edge, 154
Davis, Evelyn Y., 120, 347 Discover, 505, 555
Davis, Gray, 200 Discover Financial Services, 585
Dawes, Charles G., 568 Distorted Humor, 338
DAX Index, 475 Ditech, 502
De Kwiatkowski, Henryk, 438 DiTech Funding Corporation, 409
de la Villehuchet, René-Thierry, 443, 613 Dixon, Don, 317, 324
Dean Witter, 554 Dizona, Anthony, 202
DeConcini, Dennis, 320 Dodd, Christopher J., 401, 467, 476–477,
Defa, 657 486, 564, 634, 639, 719, 731
Del Biaggio, William, 584 Doerr, John, 133
DeLaughter, Bobby, 134 Dole Food, 135
Dell Computers, 106, 516, 620, 692 Dollar General, 276, 578
Dell, Michael, 106, 516 Dolnick, Sam, 347
Deloitte & Touche, 42, 65, 663 Donaldson, William, 68
Delphi, 65, 663 Donohue, Tom, 535
Delta Air Lines, 465, 502 Donovan, Shaun, 665
Delta Clearing Corporation, 221 Donovan, Thomas, 216
DeMizio, Darin, 176 Dooley, Evan, 502
Department of Housing and Urban Dorada, 456
Development (HUD), 308–309 Dougan, Brady, 683
Depository Trust and Clearing Corporation Douglas Aircraft, 251
(DTCC), 744 Dow Chemical, 278, 620, 635, 650
Depository Trust Company, 162–164 Dow Jones CDX Indexes, 407
Derrick, James V., Jr., 27 Dow Jones Euro Stoxx 50, 475
Designated Market Makers, 145 Dow Jones Industrial Average, 68, 128, 148,
Designed Order Turnaround (DOT), 144 158, 193, 208, 347, 413, 415, 417–419,
Deutsche Bank, 34, 56, 62–63, 82, 174, 208, 421, 424, 426, 429, 432, 434, 450, 465,
217, 253, 441, 443, 489, 494, 501, 542, 474–475, 477, 480, 482, 490, 493, 497,
545, 556, 573, 578, 597, 616, 619, 654, 504, 506–507, 510, 563, 565–566, 584,
657, 668, 677, 686, 689, 733, 745 590, 596, 606, 618, 625, 627, 634, 636,
Deutsche Bank AG, 683 650, 656, 662–663, 675, 684–686, 689,
Deutsche Börse Clearing, 165 690–691, 732, 763

Dow Jones Wilshire Banks Index, 466 EMC Mortgage, 411, 438
Drake Capital, 580 Emergency Fleet Corporation, 286
DreamWorks Animation, 610 Emperor’s Club VIP, 74–75
Dreier, 244–245 Empire Savings and Loan, 318
Dreier, Marc, 244–245 Empire Savings Bank, 317
Drew, Daniel, 175 Encore Credit, 438
Drexel Burnham Lambert, 10, 96–97, Endeavor Capital, 580
182–183, 254, 256, 318, 320, 322–323, Energy Futures Holding, 276
443, 541, 711, 715 Energy Transfer Partners, 205
Drumm, David, 615 Engineered Support Systems, 109
Drysdale Securities, 169 Enron Broadband Services, 3, 13–14, 21, 329
Dubai Ports World, 279 Enron Corporation, 3–38, 44, 47–49, 51, 53,
Dubai World, 680 59–60, 76, 78–79, 84, 97, 106–107, 114,
Dubofsky, David, 232 115, 125, 129, 133, 139, 191, 199–211,
Dudley, Robert, 516 225, 236, 239, 329–334, 341, 351–352,
Duer, William, 412 384, 419, 426, 428, 433, 436, 445, 448–
Dugan, John C. 500, 503 449, 452, 455, 459, 483–485, 489, 498,
Duke Energy, 204 508–509, 526, 534–535, 542, 553–554,
Dun & Bradstreet 754 582, 613, 632, 648, 689, 691, 711, 716,
Duncan, Dan L., 92 726, 734, 742–743, 748–749, 758–759
Duncan, David, 8–9 Enron Creditors Recovery Corporation
Duncan, Henry, 283 (ECRC), 34–35
Dune Capital Management, 516 Enron Task Force, 5, 7, 9–10, 12–14, 16–20,
Dunn, Frank A., 41–42 24–25, 28, 31, 33, 40, 49, 96–97,
Duperreault, Brain, 535 329–330, 332
Durbin, Richard, 211 EnronOnline 3, 199–200, 202, 206, 210
Dutch East India Company, 379 Enterasys Networks, 61
Dynegy, 4, 34, 36, 199, 204, 703 Enterprise Car Rental, 590
DynegyDirect, 199 ePlus, 109
Equal Employment Opportunity
E*Trade Financial Corporation, 494 Commission, 344
Eagleton, Thomas, 214 Equitable Life Assurance Society, 185, 187,
Easdaq, 147 285
Easterlin, Richard, 336 Equity Office Properties, 257
Eastern Air Lines, 251 Ernst & Young, 47, 54, 322, 530
Eastman Kodak, 423, 620, 673, 741 Ernst, Mark A., 72, 446
Ebarge, 10 Eurex Clearing, 158, 165, 215–218
Ebasco Services, 144 Euroclear Clearance System, 165
eBay, 112, 254 Euronext, 98, 150, 152, 154
Ebbers, Bernie, 6, 43–47, 54, 78, 133 Euronext Amsterdam, 269–270, 579
Economic Crisis Financial Crimes Task Euronext.liffe, 216
Force, 484 European Association of Central
Economic Recovery Advisory Board, 590 Counterparty Clearing Houses (EACH),
Education Finance, 389 166
Education Resources Institute, 390 European Central Bank (ECB), 445, 447,
Edwards, John, 339 461, 566, 574, 655, 664, 690
Eichner, Bruce, 494 European Central Securities Depositories
Eisenberg, Eugene M., 95 Association, 166
Eisenhower, Dwight D., 90, 306 European Commission, 167, 279, 644, 655,
Eisner, Michael, 106, 122 751, 764
El Paso, 199, 203–204 European Energy Exchange, 165
Elgin Capital, 581 European Systemic Risk Board, 766
Eli Lilly, 262 European Union (EU), 43, 82, 166–167,
Ellington, 432 226, 452, 461, 582, 595, 630, 649,
Ellison, Lawrence J. “Larry,” 106 636, 684, 758 657, 674–675, 685, 690, 711–712, 719,
Elson, Charles, 121 720–721, 731, 747–748, 751, 764–765

European Union Central Bank, 690 Federal Home Loan Mortgage Corporation
Eustace, Paul, 247 (Freddie Mac), 273, 310, 377–378, 381,
Evers, Medgar, 134 383–384, 387–388, 399–402, 420, 428,
Exchange Stabilization Fund, 533 431–432, 436–437, 447, 450, 464, 474,
ExxonMobil, 125, 423, 465, 502, 620 479, 483–486, 493, 506, 508, 511–512,
514–515, 520–523, 530, 563–564, 590,
Factiva, 24 595–596, 614, 616, 621, 626, 633, 637,
Fahey, John H., 298 639, 647, 650, 654, 656, 666, 671–673,
Fair Isaac Credit Organization (FICO), 677, 681, 688, 693, 696–697, 701–705,
391–392, 705, 724 709, 737, 768
Fairbanks, Richard D., 106 Federal Housing Administration (FHA),
Fairchild Engine and Airplane Corporation, 299–304, 306–308, 316 383–385,
117 394–395, 397, 446–447, 464, 486, 506,
Fairchild Semiconductor, 253 512–513, 517–518, 562, 598, 617, 634,
Fairfield Greenwich Group, 611 653, 658, 663, 671, 673, 676, 700, 768
Fakahany, Ahmass L., 549 Federal Housing Authority, 278, 309
Falciani, Herve, 64 Federal Housing Finance Agency, 522–523,
Falcon Strategies, 505 737
Fallon Capital Management, 579 Federal Housing Finance Board, 521–522
Farm Credit System, 294, 377 Federal Insurance Office (FIO), 737, 762
Farmers Loan & Trust Company, Federal Insurance Solvency Commission
285 (FISC), 186
Fastow, Andrew, 3–5, 10–11, 16, 19–20, Federal National Mortgage Association
23, 25–27, 28–32, 48, 79, 133, 330 (Fannie Mae), 273, 302–304, 306,
Fastow, Lea, 19–20 309–310, 377–379, 383–384, 387–388,
Faulkner, Danny, 318 399–402, 420, 424, 428, 431, 436–437,
Federal Accounting Standards Board 447–448, 450, 464, 474, 476–477, 479,
(FASB), 410, 448–449, 485, 514, 655, 483–486, 493, 506, 508, 510–515,
716, 718–721, 744 520–523, 563–564, 590, 595–596, 616,
Federal Agricultural Mortgage Corporation 621, 626, 633, 637, 639, 650, 654, 656,
(Farmer Mac), 383, 523 665–666, 671–673, 677–678, 681, 684,
Federal Aviation Administration (FAA), 688, 693, 696–697, 701–705, 709, 737,
603 768
Federal Deposit Insurance Corporation Federal Reserve Bank of Boston, 251, 492
(FDIC), 176, 181, 265, 291, 301, Federal Reserve Bank of New York (New
314, 316, 319, 322, 324–325, 384, York Fed), 63, 174, 183, 231, 268, 454,
396, 418, 505, 513, 515–516, 533, 522, 528, 533, 534, 543–544, 560, 569,
551, 563, 569, 587, 589, 592–594, 580, 592, 596, 639, 677, 710, 744–745
596–597, 628, 647, 651, 660, 662, Federal Reserve Bank of San Francisco,
666–668, 670-673, 680, 686, 709, 172, 427
712, 714, 716, 728–732, 737–740, Federal Reserve Board, 88
756 Federal Savings and Loan Advisory Council,
Federal Energy Regulatory Commission 295
(FERC), 201, 203–207 Federal Savings and Loan Insurance
Federal Express, 253 Corporation (FSLIC), 301, 307, 309,
Federal Family Education Loan (FFEL), 314–316, 318–319, 322
389–390 Federal Trade Commission (FTC), 95, 186,
Federal Family Education Loan Program, 191, 207–208, 396, 438, 479, 728, 757
388 Federal Work-Study, 387
Federal Financing Bank, 387 Feinberg, Kenneth, 553–554, 638–641,
Federal Home Loan Bank Board (FHLBB), 758–759
295–298, 309, 316, 318, 321–322, 324, Fen-phen, 135
377 Ferguson, Ronald E., 537
Federal Home Loan Banks (FHLBs), 383, Ferrari, 468
420, 464, 483, 506, 515, 521-523, 621, FHASecure, 518
654, 709 Fiat, 604–606, 615

Fidelity Investments, 113, 240, 271–272, First National City Corporation, 454
588, 609 First Plus, 409–410
Fiderion Group, 641 First Priority Bank, 514
Field, Denis, 62 First Republic Bank, 272
Fields, Mark, 602 First Union, 411, 558
Fifth Third Bancorp, 423 Fischel, Daniel, 39–40
Fifth Third Bank, 500, 508, 619 Fish, Robert A., 65
Filene, Lincoln, 251 Fitch Ratings, 224, 404–405, 656, 725, 748
Fillon, François, 645 FitzPatrick, Sean, 615
Financial Accounting Standards Board Five Finance, 456
(FASB), 106, 107, 180, 410, 448–449, Fixed Income Clearing Corporation (FICC),
485, 513, 655, 716, 718–721, 744 172
Financial Corporation of America (FCA), Fleet Bank, 325
317–318 FleetBoston, 253
Financial Crisis Advisory Group, 721 FLIR Systems, 55
Financial Crisis Inquiry Commission Flores, James C., 95
(FCIC), 696, 733 Florida Local Government Investment Pool
Financial Fraud Enforcement Task Force, (LGIP), 459
332, 679 Flowers, 573
Financial Guaranty Insurance Company, 502 Flowers, J. Christopher, 516, 656
Financial Industry Regulatory Authority Focus Capital, 580
(FINRA), 71, 152, 198, 223, 490, 510, Fond du Lac State Bank, 291
610, 612, 715, 728 Food Administration, 294
Financial Instruments Exchange (Finex), Forbes, Walter, 53–54
206 Ford Motor Company, 68, 112, 275, 423,
Financial Literacy and Education 495, 502, 600–604, 606, 622, 654, 667,
Commission, 757 684, 687, 692, 753
Financial Planning Association, 155–156 Ford Motor Credit Company, 647
Financial Security Assurance, 405 Ford, Bill, 692
Financial Services Authority (FSA), Ford, Gerald, 207
155–156, 206, 210, 452–453, 481, 510, Ford, Harrison, 341
513, 528, 644–645, 762–764 Ford, Henry, II, 112–113
Financial Services Roundtable, 81 Forney, John, 200
Financial Stability Board (FSB), 655, 765 Forte, Joseph, 614
Financial Stability Forum, 514, 644, 655 Fortis, 508, 573
Financial Stability Oversight Council Fortress Investment Group, 244–245, 339,
(FSOC), 737, 762 442, 580, 582, 677
Financing Corporation (FICO), 322 Fortress Re, 65
Fink, Laurence D., “Larry,” 272–273, 381 Fortune 500, 52, 112, 178, 252
Fiorina, Carly, 94 FOXNews, 641, 699
Firebrand Partners, 345 Frank, Barney, 401, 467, 485–486, 626, 638,
First Alliance Mortgage Corporation, 396, 641, 756
411 Frank, Herbert H., 642
First Beneficial Mortgage Corporation, 380 Frank, Thomas, 347
First Boston, 255, 272, 381 Frankfort Stock Exchange, 150, 165
First City National Bank, 594 Franklin Bank, 589
First Data Corp., 276, 444, 578 Franklin Savings Association, 319
First Federal Bank, 516 Franklin, Benjamin, 249, 283
First Franklin Financial Corporation, 548 Freidman, Fleischer, & Lowe, 390
First Heritage Bank, 514 Fremont General Corporation, 503
First Horizon National Bank, 398, 508 Friedman, Milton, 387, 710, 716
First National Bank, 514, 647 Friedman, Stephen, 560
First National Bank of New York, 454 Friehling, David G., 612
First National City Bank, 454 Friend, Irwin, 311
First National City Bank of New York, 454 Frist, Bill, 256
First National City Bank, 171 Fuhs, William, 10, 13

Fuld, Richard, 430, 468, 524–530 Giuliani Partners, 97

Futter, Ellen V., 758 Giuliani, Rudolph, 39, 96–97, 327, 329
FutureCom, 217 Gladstone, Larry, 494
Glanville, 281
Gableman, Michael, 128 GlaxoSmithKline, 57, 119, 131
Galleon Group, 727 Glendale Federal Bank, 323
Galloway, Scott, 345 Glenn, David, 399
Gann, Scott, 237–238 Glenn, John, 320
Gannett, 345 GLG Partners, 176
Garand, Christopher P., 537 Glisan, Ben F., Jr., 11, 25–26
Garcia, Michael, 746 Glitnir Bank, 574
Gates, Bill, 348, 481, 620 Global Crossing, 43
Gateway Capital, 247 Global Equity Opportunities (GEO), 447
GE Capital, 258, 463, 635 Global Exchange (Globex), 148, 213–214,
Geely Holding Group 684 218
Geiger, Todd, 203 Global High Wealth Industry, 62
Geithner, Timothy F., 174, 528, 560, 576– Global Investment & Wealth Management
577, 592, 629, 639–640, 642, 651–652, (GIWN), 272
665–666, 673, 677, 710, 729–730, 737, Global Investment House, 627
744–745, 747, 756 Global Wealth Management, 272, 636
Gelb, Peter, 338 GMAC Financial Services, 441, 600–601,
GEMCO, 146 610–611, 658
Gemstar-TV Guide, 78 Goal Financial, 389
Genader, Robert J., 403 Golden State Bancorp, 323
Genentech, 253, 650 Golden West Financial Corporation (Golden
General Electric (GE), 450, 463, 570–571, West), 394, 558–559
596, 628, 635, 654, 667, 677, 692, 764 Golden, Michael, 346
General Electric Capital Corporation, 628 Goldman Sachs, 67, 69, 70, 82, 119, 141,
General Electric, 14, 29, 62, 66, 99, 104, 144, 147, 151, 154–155, 183–184, 206,
107, 113, 258 208, 231, 236, 246, 276, 344, 382, 390,
General Growth Properties, 656 402, 27–428, 430–432, 441, 446–447,
General Motors (GM), 41, 68, 261, 342, 423, 456, 463, 465, 468, 487, 489, 496, 504,
426, 441, 449–450, 502, 504, 510, 547, 507, 511, 516, 524–525, 527–529, 536,
600–602, 604, 606–607, 628, 633–634, 541–545, 549, 552, 556, 559–560, 565,
640, 654, 663, 667, 681, 687, 692, 745 569–570, 581, 585, 589, 591, 593, 597,
General Re (Gen Re), 537–538 616, 619, 637, 639, 643, 654, 657–660,
Gensler, Gary, 560, 631 664–666, 668, 676, 683, 685, 688–689,
Geoghegan, Michael, 635 692, 696, 715, 719, 727, 731–736,
George M. Forman, 290 740–741, 746, 748, 750
Georgia Pacific, 259 Goldman Sachs Global Alpha Fund, 447
Getco, 145, 154 Goldsmith, Sir James, 254
GFINet System, 147 Gonzales, Alberto R., 50
Gibson Greetings, 254 Gonzalez, Albert, 671
Gibson, Mel, 337 Goodwin, Sir Fred, 644
Gifford, John, 109 Google, 71, 112, 253, 262, 487
Gilbert, Eddie, 111 Gordon, Daniel, 203
Gilbert, John, 118 Gordon, Steven, 615
Gilbert, Lewis, 118 Gore, Al, 253, 583, 703
Gillan, Kayla, 121, 344 Gorelick, Jamie, 401, 702
Gillette, 94 Gorman, James, 674, 682
Gilman, William 535 Gorton, Gary, 542
Gilmore, Vanessa, 14–15 Gottschalg, Oliver, 275
Gingrich, Newt, 127 Govan, Michael, 338
Giovannini Group, 167 Government Accountability Office (GAO),
Giovannini, Alberto, 167 210, 228, 244, 342, 378, 674, 679, 739,
Giuliani Capital Advisors, 97 741

Government National Mortgage Association Grubman, Jack, 66

(GNMA or Ginnie Mae), 164, 309, GSO Capital Partners, 261
377, 379–383, 387, 420, 493, 621, Guaranty Financial Group, 671
663, 671 Guaranty Trust Company of New York, 301
Government of Singapore Investment Guggenheim Partners, 582, 596
Corporation, 276–277, 683 Gulf Bank, 576
Government Securities Clearing Gunther IV, 338
Corporation, 163, 223 Guttenberg, Michael, 459
Gradient Analytics, 69
Graham family, 349 H.O. Stone, 290
Graham, Robert, 537 H&R Block, 72, 432, 446
Grain Corporation, 294 Haack, Robert, 181
Gramm, Phil, 587, 698, 701 Habitat for Humanity, 477
Grand Canyon Education, 593 Haldeman, Charles, Jr., 656
Grant & Ward, 413 Hale, Nathan, 96
Grant Street National, 594 Haligiannis, Angelo, 246
Grant Thornton, 57, 83 Hall, Andrew, 641
Grant, James, 518 Halliburton, 629
Grant, Tone, 248 Hambrecht & Quist, 253
Grant, Ulysses S., 413 Hamilton Bancorp, 231
Grassley, Charles, 544, 631 Hannon, Kevin, 215
Grasso, Richard, 70–72, 89, 94, 97–100, Harbinger Capital Partners, 345
102, 139, 150–151, 327–328, 427, 544, Hard Rock Park, 625
565 Harding, Raymond B., 73
Great South Bancorp, 619 Harman International, 441
Great Western Financial Corporation, 308 Harmon, Melinda, 9
Green Point, 445 Harrah’s Entertainment, 94, 443
Green, Jeff, 581 Harriman, Henry I., 299
Greenberg, Alan “Ace,” 437 Harriman, W. Averell, 298
Greenberg, Hank, 71, 328, 332 Harris, Charles L., 246
Greenberg, Jeffery W., 535 Hartford Financial Services Group,
Greenberg, Maurice R. “Hank,” 447, 187–188, 238, 520, 620
526, 535–536, 538–541, 545–547, Havens, John, 456, 505
639–640 Hawaiian Telecom Communication, 271
Greenbrier Resort, 263 Hayden Stone, 252
Greenebaum Sons Investment, 290 Hayward, Tony, 689
Greenfield, Van D., 47 Hazan Capital Management, 176
Greenspan, Alan, 218, 397, 402, 417–422, HBOS, 573, 620, 644
424–425, 462, 474, 581, 586–587, 694, HCA, 256–257
700, 706, 733 HealthSouth, 47–48, 51, 121
Greenspon, Carolyn, 346 Healy, Robert E., 716
Greenstein, Jeffrey L., 273 Hearst, 345
Greenwich Financial Services Distressed Hearst, Robert, 449
Mortgage Fund, 479 Heath, Daniel, 331
Greenwood, Paul, 632 Hedgebay Trading, 672
Gregory, Joseph M., 526 HedgeStreet, 217
Gretzky, Wayne, 476 Heekin-Canedy, Scott, 346
Grigg, Gordon, 609 Hefner, Hugh, 113
Grimsson, Olafur, 575 Heilig-Meyers, 508
Grisham, John, 128 Heinen, Nancy R., 109
Group of Seven, 577 Hellman & Friedman, 530
Group of Ten, 166, 173–174 Helmsley, Leona, 338
Group of Thirty Financial Reform Working Hendrick, Max, II, 24
Group, 590 Henry Hub, 202
Group of Twenty, 180, 577, 582, 593, 644, Hensarling, Jeb, 131
655, 674, 691, 713, 765 Hertz, 275, 625

Hester, Stephen, 644 HSBC Holdings PLC, 64

Hevesi, Alan, 72–73, 265–266, 343 HSH Nordbank, 520
Hewlett-Packard Co.(HP), 94, 253, 692 Hsu, Norman, 609
Hewlett, Walter B., 117 Hu, Henry, 121
Hexion Specialty Chemicals, 578 Hubbard, Gardiner Greene, 251
High Voltage Engineering Company, 251 Hughes, Charles Evan, 185, 327
High Yield Debt Index, 407 Hughes, Harry, 319
Highbridge Capital Management, 582 Hummer, 605
Highlands Capital, 647 Hunt family, 546
Hiller, David, 348 Hunt, Jim, 311
Hilton Hotels, 257, 269 Hunter, Arthur, 186
Hirko, Joseph, 15 Hunter, Brian, 205
Hittner, David, 20 Huntington Bancshares, 508
Hohn, Christopher, 262 Huntsman Corporation, 443, 578
Holland Land Company, 249 Hurd, Mark, 692
Hollinger International, 57-58 Hurricane Katrina, 134, 205, 329, 422, 725
Hollyday, Guy T.O., 306 Hurricane Rita, 205
Home Affordable Modification Program, HVB Group, 62
693 Hyde, James, 185
Home Affordable Refinance Program Hypo Real Estate Holdings Group, 442, 481,
(HARP), 665 573, 656
Home Depot, 70, 104, 433, 442, 520, 628,
671 IAC/Interactive, 103
Home Owner’s Loan Corporation (HOLC), Iacocca, Lee, 600, 603
297–298 IBM, 270, 628, 677, 727
Home Ownership Preservation Foundation, IBOXX, 407
699 Icahn, Carl, 254, 259, 261, 519
Home State Savings, 319 Ice Clear US, 223
Homestore, 54–55 ICE Futures Europe, 206, 208, 210
Honda, 607 ICE Futures U.S., 206
Honeywell, 764 iFund, 253
Hoover, Herbert, 89, 286–287, 294–296, Iger, Robert A., 122, 636
302, 568, 710 IKB Deutsche Industriebank AG (IKB), 445,
Hope for Homeowners, 518 734, 736
Horwitz, Don L., 531 IMC Mortgage, 410
Houldsworth, John, 537 ImClone, 262
House Committee on Oversight and Immelt, Jeffrey, 571
Government Reform, 503, 564 Impac Companies, 445, 449
House of Commons Treasury Committee, Imperial Savings Association, 260
452 Incomco, 225
Household Finance, 397, 635 Independent Bank of Michigan, 591
Household International, 397, 408 Independent National Mortgage Corporation
Housing and Home Finance Agency, 303 (IndyMac), 431, 433, 436, 514–516
Housing and Urban Development (HUD), Indiana Company, 249
378, 397, 451, 517–518, 665, 699, 701, IndyBank, 516
704–705, 757 ING Group, 520, 572
Housing Corporation, 286, 294 Inspector Javert, 6
Housing Enterprise for the Less Privileged Instinet Group, 146–149
(HELP), 704 Institutional Network Corporation, 146
Housing Finance Agency, 304 Institutional Shareholder Services (ISS), 179
Houston Astros, 34 Integrated Resources, 323
Houston Natural Gas, 18, 34 Intel, 68, 112, 251–252, 520, 692, 694, 727,
Howard, Kevin A., 15 764
Howard, Timothy J., 401 Interactive Brokers, 465
HSBC, 408, 428, 432, 445, 453, 456, 508, IntercontinentalExchange (ICE), 205, 223,
520, 611, 635, 655, 668 745

Internal Revenue Service (IRS), 96, 100, Jha, Sanjay, 636

115, 265 Jiabao, Wen, 576, 628
International Accounting Standards Board Jianyin Investments, 278
(IASB), 720–721 Jim Walter Corporation, 323
International Brotherhood of Electrical Jobs, Steve, 109
Workers Pension Fund, 129 Jockey Club, 340
International Futures Exchange (Intex), 213 John Deere, 687, 692
International Harvester, 324 John F. Kennedy Center for the Performing
International Management Associates, 246 Arts, 338
International Monetary Fund (IMF), 276, Johnson, Charles E., Jr., 54–55
279, 416–417, 499, 503, 574, 576–577, Johnson, Edward C., II, 271
592, 628, 655, 657, 674, 713, 730 Johnson, F. Ross, 255–256
International Organization of Securities Johnson, James, 401, 477
Commissions (IOSCO), 166–167, 174, Johnson, Lyndon B., 457
199 Johnson, Ned, 271
International Petroleum Exchange, 206 Jones, Alfred Winslow, 227–228
International Prisoner Transfer Program, 17 Jones, Barbara, 6, 46
International Stock Exchange (ISE), 158 Jones, Day, Reaves, & Pogue, 321
International Swap Dealers Association Jones, Edward D., 163
(ISDA), 196 Jones, Jesse, 568
International Swaps and Derivatives Jordan, Ruth, 52
Association (ISDA), 196, 458, 540 JPMorgan Chase, 34–35, 70, 82, 172, 174,
InterNorth, 18, 34 178–179, 217, 259, 334, 390–391,
Intuit, 71 407–408, 428, 442, 452, 456, 463,
Invemed Associates, 70, 99 479, 480, 496–498, 504–507, 511, 513,
Invesco, 534 527–528, 534, 558, 567, 581–582, 584,
Investment Company Institute, 533 587, 596, 599, 608–609, 611, 613, 616,
iPhone, 37, 253 619, 626, 629, 635, 637, 639, 643, 654,
iPod, 253 656–660, 674, 680, 686–687, 698–699,
Iranian Oil Stabilization Fund, 277 741, 746, 763
Irish Garda, 615 JWM Partners, 580
Irish Stock Exchange, 165
Island ECN, 147–148 Kahanek, Shelia, 10–11
Israel, Samuel, III, 246 Kahn, Roomy, 727
Ivy Asset Management, 613 Kaiser, Michael M., 338
Kajeet Inc., 488
J.B. Watkins Land Mortgage Company, 285 Kanas, John, 94
J.C. Flowers, 390, 442 Kaplan, 348
J.D. Reynolds, 234 Kaplan, Lewis, 61
Jackson, Andrew, 95, 294, 412 Karatz, Bruce, 110
Jackson, Frank G., 509 Karl, Max, 308
Jackson, Jesse, 8 Karvellas, Steven, 214
Jackson, Robert J., 96 Kashkari, Neel T., 565
Jacobs, Irwin, 254 Katten Muchin, 591
Jaguar, 495 Katzenberg, Jeffrey, 610
James River Company, 249 Kaufman, Henry, 532–533
James, LeBron, 337–338 Kaye, Scholer, Fireman, Hays, & Handler,
Jana Partners, 262 321
Janus Capital Management, 238, 460 KB Homes, 110, 424, 430, 433, 435, 467,
Jay Cooke & Company, 412 494, 622, 653, 664, 702
Jefferson, Thomas, 249 Keating, Charles H., Jr., 320
Jeffries Group, 464 Keker, John W., 133
Jenkins, Maynard, 78 Kellermann, David, 614
Jensen, Michael, 104 Kelly, Anastasia, 678
Jensen, Stephanie, 110 Kelly, Edward, 659
Jester, Dan, 560 Kelly, Robert, 553

Kennedy, John F., 90, 122, 311, 457, 592 Kroll, Jules B., 753
Kennedy, Joseph P., 49 Kuhn Loeb, 524
Kennedy, Kerry, 704 Kumar, Sanjay, 56
Kennedy, Robert, 328, 704 Kurer, Peter, 500
Kennedy, Ted, 339, 684, 731 Kuwait Investment Authority (KIA), 276,
Kerkorian, Kirk, 261, 600,602, 605 278, 576
Kerry, John, 339 Kvalheim, Grant, 452
Kerry, Teresa Heinz, 339
Kerviel, Jérôme, 475 La Grenouille, 57
KeyCorp, 508 Lackner Butz, 290
Khuzami, Robert, 733 Lady Gaga, 758
Killefer, Nancy, 592 Laffer, Arthur, 91
Killinger, Kerry, 558 Lake, Simeon T., III, 20–21, 25, 29–32, 36
Kilts, James, 94 Lampert, Edward, 434
King Mambo, 338 Lancer Group, 248
King, Leroy, 632 Land Rover, 495
King, Mervyn, 644, 673, 763 Landis, James, 592
King, Stephen, 341 Landon, Alf, 114
Kingate Management, 611 Landsbanki, 575
Kipnis, Mark, 58 Langford, Larry, 491
Kirkland & Ellis, 35 Langone, Kenneth, 70, 99–100, 611
Kissinger, Henry, 57 LaPierre, Al, 491
Kitchen, Louise, 199 LaSalle Bank, 480
KKR Financial Holdings, 269 Lauer, Michael, 248
KKR Private Equity Investors (KPE), 253 Lavielle, Brian, 204
KL Group, 609 Lawson, Bill, 30
Kleiner, Eugene, 317–318 Lay, Kenneth, 3–6, 11, 14–15, 18–30, 34,
Kleiner, Perkins, Caufield, & Byers, 253, 36, 40, 48, 78–79, 200, 330, 478
583 Lazar, Seymour M., 132
Kmart, 59 Lazard, 95
Knapp, Charles, 317–318 Lear Corporation, 262, 606
Knickerbocker Trust Company, 413 Lee Equity Partners, 442
Knight-Ridder, 146 Lee, Thomas H., 442
Koenig, Mark, 21 Leeson, Nick, 475
Kohlberg Kravis & Roberts (KKR), 254– Legg Mason, 274, 460, 501, 619
258, 265, 269–270, 276, 323, 440–441, Legg Mason Value Trust, 423, 501
443–444, 578–579, 582, 670, 673, 693 Lehman Brothers, 34–35, 43, 155, 170,
Kohlberger, James, 345 183, 236, 268, 289, 325, 402, 425, 428,
Kolchinsky, Eric, 754 430, 434, 445, 453, 463, 482, 487, 504,
Komansky, David, 611 511–512, 516, 523–524, 540, 542, 550,
Kopper, Michael, 16 556–558, 561, 570, 574–575, 585, 590,
Korea Development Bank, 528 597, 608, 614, 619, 649, 654, 678, 683,
Korean Investment Corporation, 276 710–711, 714, 726, 731, 744–745, 760,
Kovacevich, Richard, 82 767
Kovachev, Kosta, 245 Lehman Brothers Holdings, 411, 442,
Kozlowski, Dennis, 51–53, 113 468–469, 512, 533, 608
Kozlowski, Karen, 52 Lehman, Herbert H., 289
KPMG, 60–62, 65, 433 Lender Implode-o-Meter, 506
Kramer, Timothy, 204 Lennar, 494
Krause, Peter, 552 Leno, Jay, 337
Krautz, Michael W., 15 Lerach, William, 22, 36, 40, 132–134
Kravis, Henry, 269–270, 276, 578 Letterman, David, 337
Krawcheck, Sallie, 636 Levin, Carl, 208, 631, 636
Krens, Thomas, 338 Levin, Sander, 275
Kroger, 56 Levine, Dennis, 256
Kroll Associates, 53, 502, 753 Levinson, Adam, 244

Levitt & Sons, 305, 467 Long Term Capital Management (LTCM),
Levitt, Abraham, 305 179, 230–231, 417, 525, 580
Levitt, Arthur, 79, 148, 538 Lord, Albert, L., 390
Levittown, 305–306 Los Angeles County Museum of Art, 338
Levy, Richard, 338 Lott, Trent, 134
Lewinsky, Monica, 54 Louisiana Sheriffs’ Pension and Relief Fund,
Lewis, Joseph, 499 129
Lewis, Kenneth, 116, 124–125, 430, 441, Lowe’s, 104, 520, 671
528, 551–553, 619, 635–637, 682, 704 Lowitt, Ian T., 530
Lewis, Michaelm 734 Lowry, Glenn, 338, 758
Lewis, Salim “Cy,” 437 Loyal Company, 249
Lexecon, 40 Lubben, David, 108
Li, David, 260, 347, 724 Lucas, George, 337
Libyan Investment Authority, 277 Lucent Technologies, 38–39
Liddy, Edward M., 544, 560, 639 Lynch, Edmund, 546
Lieberman, Joseph, 211 Lynch, Peter, 113–114, 271
Liechti, Martin, 63 LyondellBasell Industries, 618
Lilien, R. Jarrett, 495
Limbaugh, Rush, 337 Mack, John, 116, 456, 469, 555–557,
Lincoln Center for the Performing Arts, 338 674
Lincoln National, 187–188, 691 Macomb, Alexander, 412
Lincoln Savings & Loan Association, Macquarie Group, 570
320–321 Macy’s, 628, 634
Lincoln, Abraham, 122 Madison Dearborn Partners, 257, 443
Linens ’n Things, 443 Madoff, Bernard L., “Bernie,” 6, 133, 148,
Litan, Bob, 239 236, 248, 331, 443, 533, 608–615, 631,
Litowitz, Alec, 581 726, 742, 747
Little, Arthur D., 162 Madoff, Ruth, 611
LJM Swap Sub, 16 Madonna, 337
LJM1, 3, 23 Magellan Fund, 113, 271–272
LJM2, 3, 23 Maggio, Santo, 248
Lloyds, 572–573, 668, 679, 762 Magna International, 606
Lloyds Banking Group, 620, 677 Magnetar Capital, 581
Lloyds TSB Group, 627 Maheras, Thomas, 501
Loan Guaranty Board, 600 Maiden Lane III, 544
Lobsiger, Lydia, 291 Major League Baseball, 337
Lockhart, James B., III, 437, 523 Major, John, 270
Lockheed, 418 Making Home Affordable, 676
Loeb, David S., 476, 514 Malone, Wallace D., Jr., 103
Loehr, Christopher, 24 Mamma.com, 608
Loglisci, David, 73 Man Financial, 247
Logue, Ronald, 637 Man Group, 245, 247, 520, 611
London Interbank Offered Rate (LIBOR), Managed Funds Association, 242
420, 487, 505, 546, 561, 665 Manhattan Investment Fund, 247
London International Commodity Clearing ManorCare, 279
House, 213 Marin, Richard, 439
London International Financial Futures Marino, Daniel, 246
Exchange (LIFFE), 215–216 Mark, Reuben, 103
London Scottish Bank, 453 MarketXT, 147
London Stock Exchange, 80, 84, 98, Markit Group Holdings, 746
147–148, 150, 155, 165 Markit Partners, 407
Long Beach Financial, 557 Markopolos, Harry, 612
Long Beach Mortgage Company, 409, 435 Marmon Holdings, 465
Long Beach Savings & Loan, 435 Marquez, James G., 246
Long Distance Discount Services (LDDS), Marsh & McLennan, 271, 502, 534–535,
43 691, 753

Marsh, Inc., 535 Meriweather, John, 580

Marshall, John, 158 Merkel, Angela, 663, 763
Martin, Mike, 47 Merkin, Ezra, 610–611
Martin, William McChesney, Jr., 144, 650 Merrill Lynch, 6, 10–13, 35–36, 53, 66–69,
Marx Brothers, 288 116, 124–125, 129, 147, 151, 168, 183,
Maryknoll Sisters, 688 203, 213, 217, 236, 238, 272–274, 277,
Masferrer, Eduardo, 231 314, 329, 382, 402, 405, 411, 420, 439,
Massachusetts Land Bank, 283 446, 463, 469, 482, 487, 489, 504, 509,
Massachusetts Mutual Life Insurance 512, 529, 543, 545–553, 555–556, 560,
Company, 611 564, 608–609, 611, 620, 636, 641, 643,
Massachusetts Turnpike Authority, 597 654, 659, 673, 682, 688, 701, 704, 711,
Master Liquidity Enhancement Conduit 714–715, 717–718, 726, 731, 762
(MLEC), 456 Merrill Lynch Bank & Trust, 272
MATIF, 215 Merrill Lynch Global Private Equity, 275,
Mauro, Martin, 489 443
Maxim Integrated Products, 109 Merrill Lynch Investment Management
Mayer Brown, 248 Group, 273
Mayflower Hotel, 75 Merrill Lynch Ready Assets Trust, 314
MBank, 487 Merrill Scott & Associates, 61
MBIA, 403–406, 688 Merrill, Charles, 546
MCA Financial, 384 Merritt Commercial Savings and Loan
McAfee, 33, 111, 694 Association, 319
McBirney, “Fast Eddie,” 324 Messier, Jean-Marie, 78, 126
McCain, John, 91–93, 320, 401, 485, 563 Metropolitan Life Insurance Company
McCall, Carl, 99 (MetLife), 187–188, 443, 520, 639, 683,
McCarthy, Ian J., 78 720
McCaskill, Claire, 637 Metropolitan Museum of Art, 85
McClendon, Aubrey, 636–637 Metropolitan Opera, 338
McCleskey, Scott, 754 Metts, J. Mark, 27
McCormick, Robert R., 348 Metzenbaum, Howard, 340
McDonald, John, 59 Meurs, Michael, 56
McGuire, William, 106, 108–109 Meyer, Saul, 73
MCI Communications, 43 MF Global Holdings, 245, 247, 465, 502,
McKelvey, Andrew, 111 560, 692
McKinnell, Henry, 94 MGIC Investment Corp., 405
McKinsey & Company, 18, 727 Miami Heat, 338
McLeod-USA, 70 MIBA, 404–405, 570
McLeod, Clark E., 70 Michaels, 257
McMahon, Jeff, 10 Microsoft, 71, 262, 481, 620, 625, 634, 654,
McNenney, Edward J., 535 667, 692, 764
McNerney, W. James, Jr., 95 Mid-American Energy Holdings, 34
McQuade, Eugene, 437 Midwest Stock Exchange, 148
McVay, Malcolm, 47 Miekka, James, 694
Means, Gardiner, 86 Miers, Harriet E., 51
Medicaid, 661, 651 Milberg Weiss & Bershad, 41, 53, 132–133
Medicare, 424, 495, 592, 661 Milken, Michael, 10, 39, 96–97, 182, 254,
Medill, Joseph, 348 256, 318, 320, 322
Mehta, Zarin, 338 Millard, Charles E.F., 344, 666
Melamed, Leo, 212–213, 215 Millennium Partners, 745
Mellon Bank, 594 Miller, Bill, 423, 501
Mellon, Andrew, 85, 89, 91, 96, 710 Milton, Christian, 537
Mercantile Trust, 285 Minsky, Hyman, 412
Mercedes-Benz, 62, 89, 528, 662 Minute Maid, 251
Merck, 62, 130–131, 650 Mirant, 199
Merckle, Adolf, 614 Missal, Michael J., 433
Mercury Interactive, 108–109 Mitchell, Charles E., 87–88, 454

Mitsubishi UFG Financial Group (MUFG), Murphy, Kevin, 104

557 Murray, Bronson, 224
Mitsubishi UFJ, 575 Museum of Modern Art, 338, 758
Mizuho Financial Group, 501 Mustier, Jean-Pierre, 475
Moffett, David, 633, 656 Mutual Life Insurance Company of New
Moffett, James, 299 York, 187
Money Market Investor Funding Facility Mutual Mortgage Insurance Fund, 305, 383
(MMIFF), 534, 709 Myers, David, 46
Money Market Mutual Fund Liquidity
Facility (AMLF), 709 Nabors Industries, 95
Money Store, 409, 411 Nacchio, Joseph, 39–40
Monrad, Elizabeth, 537 Nadel, Arthur, 614
Monster Worldwide, 108, 111 Napier, Richard, 537
Montag, Thomas, 552, 682 Napoli, Paul J., 135
Montgomery Securities, 253 Nardelli, Robert, 104
Moody’s Investor Services, 178, 224, 275, NASDAQ, 80, 84, 98, 142–143, 145–155,
404–405, 435, 446–447, 459, 501, 616, 157, 158, 167, 193, 206, 239, 257–258,
627, 647, 656, 719, 724, 748–751, 754 277, 418–419, 424, 474, 538, 610, 681
Moonves, Leslie, 337 NASDAQ OMX Group, 158, 167
Moore, R.M., 48 Nathanson, Colin, 615
Morgan Crucible, 17 National Asset Management Agency
Morgan Guaranty Trust Company, 165 (NAMA), 573
Morgan Library, 85 National Association of Criminal Defense
Morgan Stanley, 57, 68, 70, 116, 122, 147, Lawyers, 71
176, 183–184, 236, 238, 261, 274, 277, National Association of Insurance
345, 426, 428, 433, 436, 456, 459, 469, Commissioners (NAIC), 186–187, 754
487–489, 504, 512, 529, 543, 554–557, National Association of Real Estate Boards,
568–569, 589–590, 595–596, 616, 619, 295
639, 643–644, 654, 658–660, 668, 674, National Association of Realtors, 467
677, 682, 689, 692, 715, 733, 740 National Association of Securities Dealers
Morgan, Henry S., 554 (NASD), 53, 70–71, 152, 162, 198, 223,
Morgan, J.P, 85, 86, 96, 250, 285, 413, 460, 232, 234, 610
497, 554 National Bank, 396
Morgenthau, Robert M., 214 National Bank of Hungry, 574
Morris, Henry, 73 National Basketball Association, 337
Morris, Robert, 249 National Bureau if Economic Research, 598
Mortgage Bankers Association, 396, 479 National City Bank, 87–88, 299, 453–454,
Mortgage Electronic Registration System 508, 568
(MERS), 479 National City Company, 453–454
Mortgage Guaranty Insurance Corporation National City Corporation, 548, 588, 619
(MGIC), 308, 699 National Cordage Company, 413
Mortgage Origination Commission (MOC), National Credit Office, 749
408 National Credit Union Administration
Motorola, 68, 119, 261, 636 (NCUA) 628,737
Moynihan, Brain T., 554, 636, 682 National Emergency Council, 297
Mozilo, Angelo, 401, 476–479, 514, 636 National Football League (NFL), 246, 337,
Mudd, Daniel, 401 476
Mueller, Edward, 506–507 National Foreclosure Mitigation Counseling,
Mukasey, Michael, 483 699
Mulally, Alan, 602, 684 National Foundation for Credit Counseling,
Mulgrew, Gary, 16–17 699
Municipal and Infrastructure Assurance National Futures Association (NFA), 198, 728
Corporation (MIAC), 570 National Gallery of Art, 338
Municipal Securities Rulemaking Board National Institutional Delivery System, 162
(MSRB), 163, 570 National Market System (NMS), 142–143,
Murdoch, Rupert, 114, 254, 347 146

National Mortgage Association, 302 New York Real Estate Securities Exchange,
National Over-the-Counter Clearing 290
Corporation, 160–161 New York State Department of Insurance, 289
National Public Finance Guarantee Corp., New York State Ethics Commission, 74
405 New York State Public Employees
National Quotations Bureau, 145 Federation (PEF), 343
National Recovery Administration, 299 New York Stock & Exchange Board, 139
National Securities Clearing Corporation New York Stock Exchange (NYSE), 27,
(NSCC), 162–164 70–71, 80, 84, 89, 94, 97–100, 124, 139,
National Stock Exchange, 148 140–162, 168, 181, 183, 189, 193–194,
Nationally Recognized Statistical Ratings 198, 206, 227, 238–239, 249, 258, 270,
Organizations (NRSROs), 749 309, 328, 377, 413–415, 418, 427, 443,
NationsBank, 253 464, 525, 544, 549, 560, 565, 611, 647,
Natixis, 573 677, 681, 684
NatWest Bank, 16 New York Times Company, 345–346, 635
Natwest Three, 15–17 New York Times News Service, 346
Negrin, Renato, 745 Newkirk, Warren H., 301
Neighborhood Assistance Corporation, 699 News Corporation, 114, 347–348
NeighborhoodWorks America, 700 Nicholas, Henry T., 110
NeighborWorks America, 698 Niederauer, Duncan, 560
Neiman Marcus, 588 Nifong, Michael, 328
Ness, Eliot, 765 Nigerian Barge Fiasco, 10–15, 17, 25, 329
Netscape, 253 Nightingale Finance, 540
Neubauer, Nikolas, 216 Nikkei Average, 567
Neuberger Investment Management 530 Nissan Motor Company, 605, 607, 647
New Century Financial Corporation Nix, 468
432–433 Nixon, Richard M., 58, 268, 311, 427, 524
New Court Securities, 253 Nomura Holdings, 501, 529, 611, 654, 667
New England Council (NEC), 251 Nordic Capital, 578
New England Industrial Development Norma CDO I, 548
Corporation (NEIDC), 251 Norman, Troy, 46
New Enterprises, 251 Norris, Ian, 17
New Fabris, 646 Nortel Network, 41–42
New Jersey Division of Investment, 480 North America Land Company, 249
New London Society United for Trade and North American Savings and Loan
Commerce, 283 Association, 319
New Orleans Employees’ Retirement North Fork Bancorp, 94
System, 544 Northern Natural Gas (NNG), 34
New York Board of Trade (NYBOT), 206, Northern Rock, 451–452, 496, 675, 762
215 Northern Trust Securities, 490, 543
New York Civil Liberties Union, 42 NorthStar Education, 389
New York Clearing Corporation, 160–161 Northwest, 502
New York Clearing House, 170, 398 NovaStar Financial, 449
New York Common Retirement Fund, 265 NQLX, 217
New York Cotton Exchange, 206 Nuveen Investments, 488
New York Futures Exchange, 206 NYSE Arca, 151, 153, 157–158, 167m 736
New York Insurance Department, 535, 538 NYSE Arca Europe, 153
New York Islanders, 632 NYSE Euronext, 100, 152–154, 221, 502
New York Life, 720 NYSEG, 198
New York Life Insurance Company, 186 NYSELiffe, 153
New York Mercantile Exchange (NYMEX),
154, 190, 195, 205, 208, 214, 218, 221, O’Brien Conan, 337
474, 509, 517 O’Mahoney, Joseph, 186
New York Mets, 641 O’Meara, Christopher, 530
New York Philharmonic, 338 O’Neal, E. Stanley, 469, 547–550, 556, 564,
New York Public Library, 85 636

Oaktree Capital Management, 670 Oracle Corp., 106, 635–636, 758

Obama, Barack, 37, 62, 64, 84, 92–93, Orbitz, 620
116–117, 119, 121, 124, 128, 156, 186, Organization for Economic Cooperation and
194, 208, 209, 265, 266, 332, 339, 344, Development (OECD), 657, 664
391, 401, 471, 477, 518, 545, 553, 560, Organization of Petroleum Exporting
563, 582–584, 586, 590, 592, 595–596, Countries (OPEC), 492, 588, 616
599–600, 603, 605–607, 626, 629–630, Ortselfen, Stefan, 734
632–635, 637–639, 641–642, 646–649, Osgood, Samuel, 453
652–653, 655–656, 662, 665–666, Ospel, Marcel, 458, 503
669–670, 672, 676, 679–680, 684–691, Osterberg, William P., 227
694, 697, 699, 710, 712, 714, 729–732, Overstock.com, 68
737, 742–743, 745, 747, 752, 755, 758, Ovitz, Michael, 88–89
763–765, 767 Owen, James, 516
Occidental Petroleum, 641 Owen, Richard, 71
Och-Ziff Capital Management, 245, 261, Oxford Provident, 284
465
Ochs-Sulzberger family, 345–346 Pacific Exchange, 147
Office Depot, 634 Pacific Life Insurance Company, 272
Office of Credit Ratings, 753 PacificAmerica Money Center, 410
Office of Federal Housing Enterprise and Pacino, Al, 609
Oversight (OFHEO), 378, 400, 402, Pahapill, Mary Anne, 41
437, 521–522 Pai, Lou, 32–33
Office of Financial Education, 757 Paine Webber, 457
Office of Financial Research, 737–738 Paine, Thomas, 249
Office of Financial Stability, 656 Palm Beach Country Club, 610
Office of Investor Advocate, 742 Palmer, Daren, 614
Office of National Insurance, 761 Pandit, Vikram S., 184, 456–457, 505, 593,
Office of the Comptroller of the Currency 619, 629, 636–637, 660, 682
(OCC), 393, 395–396, 593, 728, Pang, Danny, 631
730–731, 737, 740, 742 Paris Bourse, 150, 215
Office of Thrift Supervision (OTS), 322, Parish, Al, 615
396, 437, 515, 730–731, 740 Park Avenue Bank, 666
Ohio Company, 249 Parmalat Finanziaria, 56–57
Ohio Life Insurance and Trust Company, Parsons, Richard, 625
412 Participants Trust Company, 163
Olayan Group, 480 Paterson, David A., 343, 746
Old Court Savings and Loan Association, Patman, Wright, 306
318 Patriarch Partners, 565
Old Lane Partners, 456, 505 Patterson, Mark, 560
Olenicoff, Igor, 63 Paul, David, 320
Olis, Jamie, 36 Paul, Ron, 679
OMX, 150, 158, 167, 277 Paul, Weiss, Rifkind, Wharton, & Garrison,
OneChicago, 167, 217, 531 321
OneUnited Bank, 626 Pauley, William H., III, 69
OneWest Bank, 516 Paulson & Company, 231, 496, 582
Ontario Public Service Employees Union Paulson, Henry M., Jr., “Hank,” 76, 82, 151,
Pension Fund, 41 279, 426–427, 431–432, 444, 447, 456,
Ontario Teachers’ Pension Plan, 257, 443 485–486, 493, 496, 499, 507, 513, 522,
Ontario Teachers’ Pension Plan Board, 41 527–528, 542–543, 545, 551, 560, 562,
Opel, 606 566, 582, 591–592, 599, 626, 697, 708,
Oppenheimer, 490 710–711, 719, 728, 751
OptiMark, 147 Paulson, John, 516, 581–582, 734–736,
Options Clearing Corporation (OCC), 167, 741–742
220, 222–224 Pax World, 118
Options One, 446 Paxil, 131
Opus Capital Markets, 408 Payments Risk Committee, 174

Peacock Group, 261 Poling, Douglas, 638–639

Pell grants, 387 Pontiac, 605
Pellicano, Anthony, 89 Porsche Automobile Holdings, 607–608
Pelosi, Nancy, 117 Port Authority of New York and New Jersey,
Peloton, 580 597
Pelton, Charles, 349 Portland General Electric, 14, 29
Penn Central, 566, 749 POSIT, 147
Penn National Gaming, 442 Posner, Gail, 338
Penn Square Bank, 324, 711 Posner, Victor, 338
Penn Traffic, 56 Potash Corp., 694
Pennsylvania Higher Education Assistance Potter, William, 282
Agency, 389 Powell, Colin, 253
Pennsylvania Land Company, 249 Powell, Earl A., III, 338
Pennsylvania State Employees Retirement Power Integrations, 108, 112
System, 597 Power, Richard, 53
Pension Benefit Guaranty Corporation Powernext, 154
(PBGC), 343–344, 663, 666 President’s Working Group on Financial
Penske Automotive Group, 606 Markets (PWG), 194, 197, 243–244,
Pequot Capital Management, 555 486, 745, 751
Perelman, Ronald, 254, 261, 323, 554 Presidential Task Force on Market
Perkins loans, 387 Mechanisms, 163, 194, 220
Perkins, Steve, 664 Press, Jim, 604
Perkins, Tom, 253 Price, Joseph, 553
Perot, H. Ross, 596 Priceline.com, 253
Perpich, David, 347 PricewaterhouseCoopers, 38, 53, 65, 529,
Perry Capital, 261 536, 540
Peter Cooper Village, 685 Primex Trading, 147
Peterson, Peter G., 268, 524 Prince, Charles O., III “Chuck,” 114, 423,
Petra Capital Management, 596 428, 455–456, 480, 498, 595, 636–637
Petrocelli, Daniel, 21 Pritchard, Adam C., 764
Petters Company, 609 Pritzker family, 465
Petters, Thomas, 609 Private National Mortgage Acceptance
Pfaff, Robert, 62 Company (PennyMac), 647
Pfizer, 68. 94, 130–131, 628, 635 Proctor & Gamble, 94, 690
Phallppou, Ludovic, 275 Project Hope Now, 451
PHH, 442 Promark Global Advisors, 640
Phibro, 641 Prosperity Bank, 589
Philadelphia Alternative Asset Management ProTrust Management, 609
Co. (PAAMCO), 247 Providence Equity Partners, 257
Philadelphia Board of Trade, 167 Provident Financial, 120
Philadelphia Stock Exchange (PHLX), 144, Provisional Federal Bank (PFB), 565
149, 157, 158, 167, 249 Prudential Financial (Prudential), 187, 520,
Phipps, Henry, 251 558, 620, 683, 720
Pickens, T. Boone, Jr., 254 Prudential Securities, 409
Picower, Jeffrey L., 613 PSA Peugeot-Citroën, 607, 646
Pilgrim’s Pride, 598, 669 Public Company Accounting Oversight
PIMCO, 272, 463, 585 Board (PCAOB), 77, 334
Pinnacle Foods, 257 Public Employees Retirement System of
Pinto, Edward J., 590 Ohio, 43
Plains Exploration & Production, 95 Public Works Administration, 301
Playboy Enterprises, 113 Public-Private Investment Program (PPIP),
Plueger, John, 678 651
PLUS loans, 387 Pulte Homes, 653, 668
PNC Bank, 273 Purcell, Philip, 68, 456, 554–555
PNC Financial Services Group, 273, 423, PurchasePro.Com, 54
536, 588, 619, 635 Purtich, Richard, 132

Putin, Vladimir, 629 Renaissance Technologies, 582

Putnam Investments, 271, 534 Renault, 605, 607, 646
Putnam Prime Money Market Fund, 271, Repo 105, 526, 530
534 Research in Motion, 108
Putnam, George, 271 Reserve Bank of Australia, 505
PVM Oil Associates, 664 Reserve Primary Fund (RPF), 531–534, 556,
Pyxis, 463 649, 709
Residential Capital Corporation (ResCap),
Qatalyst Group, 71 601
Qatar Investment Authority, 277 ResMAE Mortgage Corporation, 467
Quadrangle Group, 266, 607 Resolution Trust Corporation (RTC),
Quaker Oats, 442 323–324, 438
Quantum Group, 179 Retail Energy Services, 33
Quattrone, Frank, 69–71, 133 Reuters, 146, 148, 213
Quellos Group, 273 Reyes, Gregory L., 110
Quest Software, 109 Rezko, Antoin, 477
Quinlan, Patrick D., Sr., 384–385 RFC Mortgage Company, 302
Quinn, Patrick J., 651 Rhode Island Share and Deposit Indemnity
Quotron Systems, 146 Corporation, 323
Qwest Communications International, Rhythms NetConnections, 16
39–40, 506 Ricciardi, Christopher, 549
Rice, Kenneth, 13–15, 21
Radler, F. David, 58 Richmond Capital, 580
Raines, Franklin, 400–401, 521, 702 Richter, Jeff, 200
Rajaratnam, Raj, 727 Riefler, Winfield W., 299
Raju, Ramalinga, 627 Riegle, Don, 320
Rakoff, Jed S., 553 Rieker, Paula H., 21–22
Rambus, 108 Rigas, John, 5, 42, 78
Ramsey, Michael, 21, 23, 26, 28–29 Rigas, Michael, 42
RAND Corporation, 156 Rigas, Timothy, 42
Raptors, 3, 25, 579 Ripp, Joseph A., 55
Rattner, Steven, 266, 607 RiskMetrics, 95, 121, 124, 125, 179
Ray, Glenn, 26 Risoli, Paul, 459
Raymond Jones Financial, 490 Ritchie Capital Management, 248
Raytheon, 65 Ritz-Carlton, 666
RCA, 227, 299 Riverstone Holdings, 266
Read, William A., 457 RJR Nabisco, 255, 441
Readers Digest, 671 Roberts, Brian L., 95
Reagan, Ronald, 77, 91–92, 194, 220, 315, Roberts, George, 269–270
321, 546, 649, 737 Roberts, Kent, 111
Real Mex Restaurants, 579 Robertson Stephens, 253
Reconstruction Finance Corporation (RFC), Robinson, Janet L., 346
96, 296–297, 301–303, 325, 461, 568, Rocca, Patrick, 614
652, 710, 716 Roche Holding, 650
Red Hat, 253 Rock, Arthur, 252
Redouin, Jean-Paul, 712 Rockefeller family, 91, 125, 251
Redstone, Sumner, 569 Rockefeller, John D., 85–86
Reed, John, 66, 454–455 Roddenberry, Majel Barrett, 338
Refco, 225, 248, 442 Rogers, James B., 248
Regan, Donald, 546 Rogers, Rex, 79
Regions Financial Corporation. 508, 619, Rohatyn, Felix, 586
641 Rohm & Haas, 278, 650
Reich, John, 515 Rohner, Marcel, 457
Reich, Robert, 590 Roosevelt, Franklin Delano, 49, 89–91,
Reid, Todd, 204 95–96, 185, 291, 295–299, 302–304,
Reliant Energy, 199, 201 348, 414, 592, 716, 729

Rorech, Jon-Paul, 745 Savings Association Insurance Fund (SAIF),

Rosenman, Martin, 611 322
Rosenwald, Julius, 287 Saxon Mortgage, 449
Ross, Steve, 94 SCA, 405
Ross, Wilbur L., 259, 405, 446 Scarface, 580
Rothstein, Scott, 135, 615 Schapiro, Mary, 84, 121, 149, 630–631, 642,
Rousselet, Luc, 646 690, 731–732, 747
Rove, Karl, 50–51 Schering-Plough, 650
Rowling, J.K., 340 Schiff, Frederick S., 57
Royal Ahold, 56, 276 Schmidt, Eric, 71
Royal Bank of Canada, 490, 492 Schneider, Howard, 247
Royal Bank of Scotland (RBS), 16–17, Schrenker, Marc, 614
120, 452, 501, 572–573, 595, 611, Schrenker, Michel, 614
616, 627, 644, 655, 668, 675, Schulman, Steven, 132
762 Schumacher, Michael, 337
Royal Canadian Mounted Police, 41 Schumer, Charles “Chuck,” 82, 125, 154,
Royal Dutch Shell, 120, 204, 206 325, 401, 407, 515
Royal Exchange, 643 Schwab, Charles R., 87, 468, 489–490, 501,
Royer, Jeffrey A., 609 704
Rubenstein, David, 265, 270, 277 Schwartz, Alan, 495
Rubin, Howard A., 382, 547 Schwartz, Anna, 708
Rubin, Robert, 384, 417, 456, 560, 590, Schwarzenegger, Arnold, 200
637–638, 733, 741 Schwarzman, Stephen A., 268, 524
Rubinstein, Steven M., 63 Scient, 253
Ruble, R.J., 60 Scorsese, Martin, 609
Rudman, Warren, 401 Screen Actors Guild, 340
Rural Cellular Corporation, 609 Scruggs, David (Zack), 134
Rush, Walter, 29 Scruggs, Richard “Dickie,” 134
Russell 2000, 474 Scrushy, Richard, 47–49, 51
Russo, Thomas, 678 Seagate Technology, 620
Ryan, Debra, 246 Sears, Roebuck & Co., 287
Ryder Cup, 113 SecondMarket, 155, 488, 672
Secrest, George McCall, Jr., 28
S.W. Straus, 290 Secretariat, 338
S&P 500 Index, 94, 101, 125, 159, 276, 342, Securities Industry Automation Corporation
419, 423–424, 426, 465, 493, 501, 533, (SIAC), 162
561, 569, 584, 587–588, 592, 597, 618, Securities Information Center, 161
625, 669, 681, 687, 718, 750 Securities Investor Protection Corporation
Saab, 605 (SIPC), 168, 181, 225, 314, 529, 531,
Sabath, Adolf J., 290 610, 613, 739
SafeNet, 111 Security Capital Assurance, 405
Salomon Brothers, 114, 533 Security Pacific Bank, 589
Salomon Smith Barney, 66, 70 Sedgwick, Kyra, 610
Samantha, 338 Sedna Finance, 456
Samberg, Arthur, 555 Seidman, L. William, 323
Sambol, David, 479 SelectNet, 146
Samueli, Henry, 110 Semerci, Osman, 549
Sanders, Thomas, 251 SemGroup, 265
Sandler, Herbert, 394, 559 Sempra Energy, 199, 203
Sandler, Marion, 394, 559 Senate Banking Committee, 476, 634, 731
Sankaty Advisors, 589 Sentinel Advisors, 62
Sanmina-SCI, 108 Sentinel Management Group, 225
Sants, Hector, 452, 764 Sequoia Fund, 264
Sarkozy, Nicolas, 646 Service Employees International Union
Saturn, 605–606 (SEIU), 264–265, 279, 516
Satyam Computer Services, 627 ServiceMaster, 276

Shafran, Steve, 560 Sonnenschein, 591

Shakespeare, William, 340 Sony, 646
Shapiro, Carl, 611 Soros Fund Management, 582
Shearson Hayden Stone, 524 Soros, George, 179, 230, 481, 516, 581–582,
Shearson/American Express, 524 586
Sheen, Charlie, 337 Southern Pacific Funding Corporation, 410
Shelby, Rex, 15 SouthTrust Bank, 103
Shell Trading Gas and Power Company, SouthTrust Corporation, 558
202, 620 Southwest Airlines, 465
Shelton, E. Kirk, 54 Southwest Securities, 238
Shereshevsky, Joseph, 609 Sovereign Bancorp, 94, 464, 574
Shiller, Robert, 727 Spano, John, 632
Shin Corporation, 280 Spear, Leeds, & Kellogg, 151
Shinawatra, Taksin, 280 Spector, Warren, 440, 495
Shively, Hunter, 202 Spencer, Leanne, 401
Shulman, David, 488 Spielberg, Steven, 610
Sidhu, Jay, 94 Spitzer, Eliot, 66, 75, 81, 83, 89, 97–100,
Sidley Austin Brown & Wood, 60 116, 139, 150, 231–238, 240, 327–329,
Siegelman, Don, 48–51 332, 352, 389, 398, 404, 455, 489, 498,
Siemens, 615 534–539, 541, 544, 565, 639, 703–704,
Sieracki, Eric, 479 726, 729, 732, 742–743, 746
Sigma Finance Corporation, 574 Sprecher, Jeffrey, 206
Sigma X, 155 Sprint Nextel, 464–465
Sihpol, Theodore Charles, III, 232 Sprint, 43
Silverado Savings & Loan Association, 320 SS Central America, 412
Simmons Bedding Company, 275 St. Eve, Amy, 58
Simon, William, 254 St. Regis Monarch Beach, 543
Simons, James H., 581–582 Stafford loans, 387
Simpson, Jill, 50 Stalin, Joseph, 59, 122
Simpson, O.J., 21, 54, 255 Stallone, Sylvester, 609
Singapore International Monetary Exchange Standard & Poor’s, 24, 178, 224, 404, 473,
(SIMEX), 213, 215 493, 521, 577, 585, 601, 635, 656, 661,
Singapore Investment Corporation, 702, 719, 748–751, 764
457–458, 683 Standard Oil Company, 85, 125, 299
Singleton, Greg, 204 Stanford International Bank, 631–632
Skadden Arps, Slate, Meagher & Flom, 482 Stanford, Sir R. Allen, 248, 631–632, 734
Skilling, Jeffrey, 3–6, 11, 14–15, 18–32, 36, Starbucks, 487
40, 48, 59, 79, 115, 133, 199, 200, 330, Starr International, 538–539
351, 390, 478 Starr, Kenneth, 609
Slim, Carlos, 346 State Street Bank and Trust Company, 174
SLM Corporation, 388, 442 State Street Global Advisors, 272
Small Business Administration, 251, 596 State Street Securities, 450, 463, 627, 637,
Smith Barney, 595, 608 659–660
Smith, Lanty L., 559 State Teachers Retirement System of Ohio,
Smith, Weston, 48 43
Snapple, 442 Steele, Robert J., 559–561
Snipes, Wesley, 609 Steffan, Roger, 299
Snow, John, 401, 427 Steinberg, Saul, 254
Social Security Administration, 495, 592, Steinbrück, Peer, 574
661, 687, 699, 751 Stenfors, Alexis, 551
Société Générale (SocGen), 456, 475, 501, Stephenson, Kirk, 614
520, 542, 545, 675 Stern, Andy, 264–265, 278
Society for Worldwide Interbank Financial Stern, Edward J., 231
Telecommunications (SWIFT), 172–173 Stern, Howard, 336
Solomon R. Guggenheim Museum, 338 Stevens, Ted, 331–332
Solow Realty, 245 Stewart, Alexander, 85

Stewart, Martha, 5, 262 Task Force on Payment System Principles

Stockman, David, 77 and Practices, 173
Stop & Shop, 56 Tavdy, David, 459
Storage Technology, 251 Taylor, Bean & Whitaker Mortgage
Storch, Adam, 560 Corporation, 671
Storm Cat, 338 Taylor, John, 707
Stotler Funds, 225 TCI, 263
Streiff, Christian, 607 TD Ameritrade, 490
Strike System, 147 Technical Committee of the International
Strong Mutual Fund, 231 Organization of Securities Commissions
Strum, Donald, 66 (IOSCO), 166–167, 174, 199
Student Loan Insurance Fund (SLIF), 387 Teitelbaum, Herbert, 74
Student Loan Marketing Association Teixeira, Mark, 337
(Sallie Mae), 387–388, 390–391, Teledyne, 252
687 Telerate, 146
Student Loan Xpress, 388–389 Temasek Holdings, 278, 280, 453, 550, 659
Stumpf, John G., 682 Temple, Nancy, 8–9
Stuyvesant Town, 685 Temporary Liquidity Guarantee Program
Subprime Working Group, 483 (TLGP), 709
Sullivan, Martin J., 469, 538–541, 543–544, Tepper, David, 681, 684
640 Term Asset Backed Securities Loan Facility
Sullivan, Scott, 44-46 (TALF), 391, 596, 646–647, 661, 679,
Sult, John R., 24 686, 710
Sulzberger, A.G., 347 Term Auction Facility (TAF), 674, 709
Sulzberger, Arthur, 346 Term Securities Lending Facility (TSLF), 709
Sulzberger, Arthur, Jr., 347 Terra Securities, 453
Summers, Lawrence H., “Larry,” 417, 590, Texas Instruments, 628
638, 648, 676, 733 Texas Pacific Group (TPG), 257–258, 278,
Sun Capital Partners, 579 443
Sun-Times Media, 59 Texas Rangers, 436
Sunbeam, 7, 554 Thain, John 151–152, 549–552, 560
SunTrust Bank, 426, 460, 500 Thinc Group, 481
Super-DOT, 144 Third Avenue Management, 405
Superior Bank, 396 Third National Bank, 453
SuperMontage, 146, 149 Thomas H. Lee Partners, 275, 441–442
Supervalu, 267 Thomas Weisel Partners, 253
Susquehanna Company, 249 Thompson, G. Kennedy, 559
Sutherland, Kiefer, 337 Thompson, Larry D., 6–7, 61
Swartz, Mark, 52 Thomson Learning, 441
Swiss Bancorp, 457 Thomson, James B., 227
Swiss National Bank, 461, 574 Thomson, Todd, 114
Swiss Reinsurance (Swiss Re), 481, 520, Thornburg Mortgage, 494, 502
597, 655 Thornton, Grant, 57, 83
Swiss Stock Exchange, 215 3M, 667
Syncora, 405 3Par, 692
Syron, Richard F., 464 TIAA-CRE, 79, 531
Tiffany’s, 531
T. Rowe Price Group, 480 Tiger Management, 179, 231
Take-Two Interactive Software, 65, 111 Time Warner, 620–625
Taleb, Nassim Nicholas, 149, 180, 340, 690, Time, 94
725 Times Mirror, 348
Tandem Computers, 253 Timothy Plan, 118
Tannin, Matthew, 439–440 Tishman Speyer Properties, 685
Tarbell, Ida, 85 Title Guarantee & Trust Company, 289
Target, 520, 565, 634, 712 TJ Maxx, 671
Targus Group International, 65 TNK-BP, 516

Tobin, James, 763 U.S. Central Credit Federal Union, 628

Tokyo Stock Exchange, 152 U.S. Chamber of Commerce, 81, 123, 240,
Toll Brothers, 424, 428–429, 431, 434, 445, 299, 535, 719
494, 587, 626, 636, 665, 669 U.S. Food Service, 276
Toll, Robert, 636 U.S. Mortgage Company, 285
TONTO System, 147 U.S. National Home Index, 718
Topolanek, Mirek, 649 U.S. Open, 543
Tops, 56 U.S. Postal Service, 669
Torkelsen, John, 133–134 U.S. Steel, 87
Toronto Stock Exchange, 148 UBS, 34, 56, 63–64, 154, 174, 229, 272,
Toronto Teachers Pension Plan, 245 277, 278, 404, 423, 436, 457–459,
Toronto-Dominion Bank, 34 487–488, 494–500, 503–508, 528, 545,
Tottenham Benefit Bank, 283 548, 556, 574, 597, 610, 616, 619, 635,
Tourre, Fabrice, 734–735 643, 654, 657, 668, 670, 677, 683, 685,
Towns, Edolphus, 476–477, 553 689, 692, 717, 733
Toyota Motor Co., 129, 450, 495, 504, 602, UBS AG, 640, 683, 745
607 UBS Fund Service, 247
TPG Capital, 276, 442, 558, 579 UBS Warburg, 200
Trac-X, 407 UBSWenergy.com, 200
TRACE, 149 UCBH Holdings, 619
Tracinda, 600 Unicredit, 57
Trade Information Warehouse (Warehouse), Union Bancaire Privée, 610
744 Union for Textile and Hospitality Industry
Tradewinds International II, 246 Workers, 123
Trading System, 147 Union Network International, 264
Transylvania Company, 249 Union Pacific, 285
Travelers Group, 454–455, 537, 663 United Airlines, 323, 518
Treacy, James J., 111 United Auto Workers (UAW), 602, 604–606
Tremont Group Holdings, 611 United Brands, 443
Tribune Company, 345, 348 United Brotherhood of Carpenters and
Trichet, Jean-Claude, 661, 763 Joiners of America, 122
Trigon Group, 614 United Capital, 580
Trinkle, Tina, 11 United Copper Company, 413
Trotsen, Robert, 248 United Rentals, 441
Troubled Asset Relief Program (TARP), United State Department of Agriculture
565, 567–569, 578, 584–586, 591, 596, (USDA), 599
599, 604, 606, 609, 617, 626, 629, United States Futures Exchange (USFE),
635–636, 638, 640–641, 643, 647–648, 217
651–652, 654, 656–660, 665–656, 662, United States Housing Corporation, 294
671–672, 677, 679–681, 684, 709 United States League of Local Building and
Trout Trading, 247 Loan Associations, 286, 300
Trubeck, William, 446 United Technologies, 103, 113
TRW, 442 UnitedHealth Group, 106, 108
Tucker, Paul, 452 Unites Cos Financial Corporation, 410
Tudor Investments, 579 University of Texas Investment Management
Tullos, Nancy, 110 Company, 264
Tully, Daniel, 611
Turner, Lord, 762–763 VA Linux, 253
Turquoise, 147 Valdez, 128
TXU, 257, 276, 578 Valencia, Michelle, 204
Tyco International, 51–53, 113, 129, 133 Van der Hoeven, Cees, 56
Tyson Foods, 620, 669 Van Wagoner Emerging Growth Fund, 501
Tzolov, Julian, 490 Van Wagoner, Garrett, 235, 501
Vanguard, 79
U2, 114 Varney, Christine, 764
U.S. Bancorp, 423, 460, 659 Vauxhall, 606

Veco Corporation, 331 Washington Mutual (WaMu), 420, 426, 429,

Venrock Associates, 252–253 433, 435, 442, 446, 450, 480, 484, 506,
Verizon Wireless, 609 521, 557–560, 574, 583, 587, 599, 619,
Vernon Savings Bank, 317 658, 682, 686, 698
Verrone, Robert, 559 Washington Post Company, 348–349
Vesco, Robert, 111 Washington Wizards, 338
Veterans Administration (VA), 302, 304, Washington, George T., 86, 88
309 383 Washington, George, 249
Vetra Finance, 456 Wasserstein, Bruce, 95
Viacom, 337, 569 Waste Management, 7
Villiger, Kaspar, 635 Watkins, Sherron, 4, 23–24, 27
Viniar, David, 431 Watson, Frank, 299
Vinson & Elkins, 24, 34, 79 Waxman, Henry A., 564, 636, 640
Vinson, Betty, 46 WCI Communities, 112, 519
Vioxx, 130 Weatherstone, Dennis, 179
Virginia House of Burgesses, 283 Weidner, Clinton Odell, II, 115
Virginia Yazoo Company, 249 Weil Gotshal, 529
Visa, 618 Weil, Raul, 63
Visteon, 606 Weill, Sanford “Sandy,” 66, 106, 116, 423,
Vivendi Universal, S.A., 78, 126 454–455, 457, 480, 497–498, 524, 595
Volatility Index (VIX), 159, 566 Weinstein, Boaz, 619
Volcker, Paul, 79, 414, 546, 586, 590, Weiss, Melvyn, 133
706–707, 718, 731, 740 Welch, Jack, 99, 107, 113, 571
Volkswagen, 607–608 WellPoint Inc., 689
Volume Investors, 225 Wells Fargo, 82, 394, 398, 423, 426, 434,
Volvo, 684 466, 490, 509, 512–513, 560–561,
567, 584, 616, 619, 639–640, 643, 656,
Wachovia, 103, 174, 394, 398, 411, 423, 658–659, 668, 676, 680, 682, 692
426, 441, 482, 489, 506, 545, 549, 556, Werlein, Ewing, Jr., 12
558–561, 581, 595, 619, 656, 658, Wesray, 254
711 West, Stephen K., 239
Wachovia Bank and Trust, 558 Westar Energy, 114–115
Wachovia Corporation, 558 WestLB, 456, 481
Wachovia Loan and Trust, 558 WexTrust Capital, 609
Wachovia Mortgage Corporation, 398 Weymouth, Katherine, 349
Wachovia National Bank, 558 Wharton Private Equity Forum, 265
Wachovia Securities, 488, 558 White & Case, 590–591
Waddell & Reed, 149, 690 White House Domestic Council, 427
Wagoner, George Richard “Rick,” 601, 605 Whiteacre, Edward, Jr., 692
Wakefield, Priscilla, 283 Whitehead, John C., 536
Wal-Mart, 119, 334, 434, 634 Whitney family, 251
Walker, Frank C., 298 Whitney, J.H., 251
Walker, Sir David, 644 Whitney, Richard, 141
Wall, M. Danny, 321 Wie, Michelle, 337
Wallison, Peter, 239, 399, 448 Wiesel, Elie, 610
Walsh, Mark, 526 Wilde, Oscar, 19, 330, 333, 553
Walsh, Stephen, 632 Williams Companies, 199
Walt Disney Company, 88, 95, 106, 122, Williams, Julie L., 398
636 Williams, Serena, 337
Wang, Charles, 56, 632 Willumstad, Robert, 541, 543
War Finance Corporation, 294, 568 Wilshire Banks Index, 466
War Production Board, 304 Winfrey, Oprah, 115, 337, 758
Warburg Pincus, 404 Winkelreid, Jon, 463
Warburg, Paul, 413 Winnick, Gary, 43
Warner Brothers, 94 Winnipeg Commodity Exchange, 206
Warren, Elizabeth, 732, 756 Witness Systems, 109

Wittig, David, 114–115 Yahoo!, 71, 262, 608

Wolff, Stuart, 54 Yang, Jerry, 262
Wolfowitz, Paul, 560 Yates, Buford, 46
Woodin, William, 291 Yeager, F. Scott, 14–15
Woods, Tiger, 337 Young, Phua, 53
World Bank, 560, 577, 730 YouTube, 71
World Savings Bank, 394, 558 Yuen, Henry, 78
World Trade Organization, 630
WorldCom, 4, 6, 8, 35, 43–45, 78, 84, 129, Zales, 446
236, 606 Zarb, Frank, 538
Wright, Jim, 320 Zehil, Louis W., 608
Wright, Kirk, 246 Zela Finance, 456
Wrigley Field, 348 Zell, Sam, 348
Wuffli, Peter, 457 Zimmer Holdings, 333
Wunderkinder, 610 Zions Banccorporation, 432
Wyatt, Wilson, 304 Zito, Barry, 337
Wyeth, 628 Zoellick, Robert, 560, 730
Wyly, Charles, 736 Zuckerman, Mortimer, 610
Wyly, Sam, 736 Zurich American Insurance, 537
Wyoming Mineral Trust Fund, 277 Zurich Financial, 520, 574
Xerox, 65, 674

Cumulative Subject Index
Absolute return strategies, 272 Bank capital requirements

Algorithmic trading, 146, 193 Basel I, 177
Alternative Trading Systems, 147 Basel II, 178
Annuities Basel III
fixed-index, 620 CDOs, 712
guaranteed variable counter-cyclical approach, 712, 713–74
Asian flu crisis, 417 leverage limits, 712, 714
Asset-backed commercial paper off balance sheet items, 712
background, 385 phase in, 712
Dodd-Frank, 740 response to subprime crisis, 712
subprime losses, 460 Tier 1 capital, 712
Asset management firms, 271 CAMELS, 177
Auction rate securities consolidated supervised entities, 184
auction failures, 487 cyclical concerns, 713
buybacks, 488 European Union, 711
description, 486 leverage ratio, 177
early problems, 487 mark-to-market, 177
reforms, 664 off balance sheet items, 180
Auto loan problems, 468 pro-cyclical concerns, 180
Automakers purpose, 176
bailouts, 600, 604 rating agencies role, 178
bankruptcy, 603, 606 role in subprime crisis, 711
car czar, 607, 663 TARP injections, 568–569
cash for clunkers, 607, 669 Tier 1 capital, 177
CEO changes, 692 trust preferred securities,
dealership closings, 605 prohibited, 739
executive jets, 603 use of 178, 480
hearings, 603 well capitalized, 177
job banks, 604 Banker bashing, 684, 686, 689, 730, 731, 732
losses, 601–602 Bankers’ bonus concerns, 466, 468, 589
parts dealers, 606 Bank examination fees, 730
recovery, 687 Bank failures, 503, 617, 619, 652, 662, 670,
sales, 653, 692 671, 679
unions, 604 Bank holiday, 297
Bank lending standards, 504
Bailouts Bank loan loss reserves
list of programs, 708–709 conflict with SEC, 714
TARP implemented, 565, 591 during subprime crisis, 466, 467, 500, 502,
Treasury proposal, 562 558
815

816 cumulative subject index
Bank losses, 503–504, 506, 619 Carry trades

Bank nationalization, 325, 323–324 excessive risk taking, 708
Bank payment systems hedge funds, 230
check clearing, 170–171 in Japan, 575
CHIPS, 171 subprime crisis, 707–708
clearinghouses, 170 UBS losses, 458
concerns, 173 yield curve inversion, 427
core principles, 173 Certificated mortgages, 286
Dodd-Frank, 739 Class action lawsuits
Fedwire, 172 abuses, 126
fixed-income, 172 coupon settlements, 127
generally, 170 Enron, 35
Herstatt crisis, 171 expert witnesses, 133
large value payments, 173 legislation, 127
minimum standards, 174 pension funds,126
payment-versus-payment, 172 professional plaintiffs, 232
SWIFT, 172 scandals, 131
Bank reserve requirements, 176 Class warfare, 95
Bank resolution authority, 652, 729 Clawback of compensation, 564
Bank runs, 451, 497 Clearing and settlement
Bank supervision abroad, 712 book entry securities, 163
Bank stress tests centralized clearing and settlement, 162
abroad, 674, 693 competition, 221
bank taxes continuous net settlement system, 161
Tobin tax, 763 cross-border settlements, 166
U.S. proposal, 736 cross-margining, 222
in the U.S., 629, 652, 658 daily balance order system, 161
Beige book, 502, 598, 634, 663, 680 delivery-versus-payment, 166
Blank check offerings, 465 equity options, 167
Block trades, 141 European Union, 167
Blue ribbon studies, 310 international, 165
Brady Commission, 163, 194, 220 over-the counter, 221
Broadband Services case, 13 SEC action, 160
Broker-dealer capital requirements stock certificate issues, 161
background, 181 stock exchange problems, 159
consolidated supervised entities, 183, systemic risk, 162, 166
715 T+3, 163
description, 181–182 transfer agents, 164
failure during subprime crisis, 714 Treasury study, 164–165
haircuts, 180 Collateral arrangements, 169
holding company structures, 183 Collateralized debt obligations (CDOs)
Market Reform Act of 1990, 183 cubed, 402
Brokered deposits, 515 description, 259, 402
Broker votes, 124 due diligence, 408, 509
Budget deficits fair value pricing, 717
abroad, 693 fire sales, 550
states, 406 Goldman Sachs case, 733
U.S., 425, 429, 512, 651, 661, 693, 694 losses, 674
Building and loan societies, 284 ratings downgrades, 435, 446, 447, 471,
473, 585, 621, 647
Capital requirements. See bank capital squared, 402
requirements, broker-dealer capital synthetic, 260, 402, 733
requirements, commodity market capital valuation flaws, 261
requirements, insurance industry capital Collateralized mortgage obligation, 260, 381
requirements Commercial bond market
Carried interest, 274 liquidity concerns, 461

cumulative subject index 817
Commercial bond market (continued) Commodity markets (continued)

mortgages, 661 portfolio insurance, 193
Committee on Compensation Practices, 155 portfolio margining, 223
Commodity market clearinghouses price explosions, 212
background, 218 price gouging, 207
clearing members, 219 price manipulation, 191
core principles, 219 principles based regulation, 197
cross-margining, 222 program trading, 193
good to the last drop, 219 Project A, 214
live another day, 219 regulation, 190–191
margin, 219 regulatory arbitrage, 205
registration, 219 round trip trades, 201
role, 219 runners, 214
Stock Market Crash of 1987, 220 segregation requirements, 224
Commodity markets self regulation, 198
attempted manipulation claims, 201 significant price discovery contract, 211
background, 189 SIMEX link, 213
black box trading, 213 Single stock futures, 225
boards of trade, 191 speculative limits, 210
bucket shops, 189 squeezes, 190
California electricity market, 200 stock exchange competition, 190
capital requirements, 196, 225, 521 Stock Market Crash of 1987, 193, 220
cascade theory, 193 Compensation
circuit breakers, 194 abroad, 644
clearing. See commodity market AIG bonuses, 638
clearinghouses athletes, 337
commodity option problems, 195 bank restrictions, 758
contract markets, 191 caps, 637, 642
corners, 190 clawbacks, 120, 640
crude oil prices, 207, 424 consultants, 102
difference trades, 217 corporate jets, 115, 641
dual trading, 214 corporate perks, 112, 641
dynamic hedging, 193 Contract With America, 127
electronic trading, 199, 206, 212, 218 disclosures, 102–103, 642
Enron loophole, 210 Dodd-Frank, 759
ETFs, 209 eat your own cooking, 645
event contracts, 217 entertainers, 336, 758
exempt commercial markets, 198 excessive risk taking, 640, 642, 643
false reports cases, 202 golden parachutes, 642
Federal Trade Commission golf outings, 543, 641
manipulation authority, 208 gross-ups, 643
study, 191 horses, 338
FERC memorandum of understanding, 205 not-for-profits, 338
foreign futures, 198 options, 105
futures commission merchants, 192 pay czar, 638, 638
Globex, 213, 218 populist politicians, 339, 636, 638, 730–731
index traders, 208 risk taking, 731, 759
jurisdictional fights, 194, 206 say-on-pay, 630, 759
locals, 214 scalable pay, 340
manipulation standards, 202 subprime crisis, 636, 676
margin requirements, 193, 219–220 TARP effects, 758
mergers, 2218 Consolidated supervised entities
monopoly, 191 background 183, 226
natural gas, 201 failures, 715
onion trading, 207 risk models, 715
open outcry trading, 212 SEC incompetency, 732

Constant proportion debt obligations, Fails to deliver, 159,

751 Fair value accounting
Consumer confidence background, 448, 716
debt, 423 BIS, 721
delinquencies, 693 concerns over, 448
during the crisis, 426, 436, 468, 634 congressional action, 719, 720
post-crisis, 693 European Union, 719, 720
Convertible bond arbitrage, 175 FASB
Corporate earnings, 464 adoption, 716
Corporate monitors, 333 criticism of, 721
Corporate reform failures, 351 relief, 720
Creative destruction, 711 Great depression, 716
Credit and debit cards GSEs, 447, 464
arbitration of disputes, 662 hedge funds, 229
banks, 712 held for investment, 720
delinquencies, 671 historical cost alternative, 716
interchange fees, 755 history of, 716
legislation, 662, 755 insurance industry, 719–720
losses, 474, 519 mutual funds, 235
network access, 755 pro-cyclical, 716–717
Credit crunch, 310, 441 rating agencies, 719
Credit default swaps relief from, 485, 655
AIG problems, 539 SEC
antitrust concerns, 746 action, 719
definition, 406 study, 720
insurance, as, 407 super seniors, 717
Lehman settlements, 531 temporary impairment, 719–720
regulation, 744, 746 Warren Buffett, 718
Credit insurance, 285 write-downs, 448, 494, 519
Credit union bailouts, 599, 628 Fannie Mae and Freddie Mac Capital
CUSIP, 161 requirements, 702
Custodial services, 168 Fat finger syndrome, 148
Fed interest rate increases, 421–422
Dark pools, 155 Fee based brokerage accounts, 155–156
Death spiral transactions, 176 Financial analysts scandals, 66, 68
Deferred prosecution agreements, 60, 201, Financial services legislation
333 bank tax, 736
Delaware block approach, 723 costs, 691
Deregulation debate, 728–729 Dodd-Frank
DIP financing, 571 asset-backed securities, 740
Distressed debt purchases, 670 broker-dealers
Dorian Gray theory, 18, 330 arbitrations, 742
Dot.com bubble, 418 fiduciary duties, 742
Double dip recession, 679, 694 financial analysts conflicts, 742
Bureau of Consumer Financial
eCBOT, 149 Protection, 756
Electronic communication networks clearing and settlement, 739
description, 98, 146 derivatives jurisdiction, 743
regulation, 147 CFTC, 743
Energy prices, 516 Fannie Mae and Freddie Mac, 737
English rule for attorney fees, 127 FDIC insurance, 740
Enron bankruptcy, 34 Fed audits, 739
Enron Broadband case, 13, 329 Financial Stability Oversight Council,
Enron Corporate Fraud Task Force, 5, 9 737
Exception loans, 509 hedge funds, 747
Extension risk, 381 leverage ratios, 738

Financial services legislation Hedge funds (continued)

Dodd-Frank (continued) directional trading, 223
liquidity events, 738 Dodd-Frank, 747
living wills, 739 fair value issues, 229
non-bank financial companies, 738 fees, 228
passage, 736 fund-of-fund problems, 611
predatory lending practices, 756 give-ups, 229
rating agencies, 748 growth, 227
size of reform bill, 737 hedge fund hotels, 229
SEC reforms, 742 history, 227
short sales, 747 late trading, 231
swap regulation, 743 lockups, 228, 578
TARP, 738 losses, 231, 437, 445
too-big-to-fail, 737 management, 228
systemic risk, 740 market timing, 231
Volcker rule, 740 mutual fund scandals, 231
Flash crash, 148, 689 net asset value, 228, 229
Flash orders, 154 placement agents, 610
Flipping, 421, 435 prime brokers, 228
Floor traders, 141 private equity, 261
Foreign stock delistings, 83 private offering memorandum, 241
Forex fraud, 194 profitability, 228
Fourth market, 141 public offerings, 244, 693
Free credit balances, 167 quant funds, 693
Friendly societies, 282 quants, 229
Full disclosure, 100 redemptions, 228
Functional regulation regulation
proposed reforms, 728 European Union, 747
regulators in, 728 U.S. 241, 631, 747
relative value trading, 230
Generally Accepted Accounting Principles secrecy, 230
(GAAP), 84 side pocket accounts, 229, 248
Global rescue efforts, 576 subprime crisis, 578, 620, 684
Good bank/bad bank proposals, 594 trading strategies, 229
Government Sponsored Enterprises volatility trading, 230
background, 294, 377 High frequency trading
creation, 302 description, 153–154
implied guaranty, 310 hedge funds, 230
privatization, 306, 309 Home bias, 150, 166
savings & loan crisis, 378 Home improvement loans, 301
supervision, 378 Home ownership growth, 304, 308
Great Panic, 524 Honest services fraud, 6, 12, 17, 32, 49–51,
Grocery store accounting, 56 59, 115
Hot boxed, 25
Hedge funds House lust, 42`
abuses, 245 Household wealth, 423, 468
administrators, 229 Housing boom, 304, 421
alternative assets, 229 Housing market slowdown, 423, 424, 429,
antifraud rule, 243 466, 504, 626
carried interest, 274 Housing projects, 305
carry trades, 230
clearing firms, 228, 247 Independent chairman, 124, 759
as corporate activists, 262–263 Industrial banks, 712
credit crunch, 442 Inflation
defaults, 494 Bernanke’s view, 444, 445
definition, 227 interest rate concerns, 428, 429

Inflation (continued) Managed economy, 707

Volcker actions, 414 Market fragmentation, 142
Initial public offerings Merchant banking, 250
growth in 2007, 465 Merger activity
resumption, 674 banks
subprime crisis, 510, 519, 618 Community Reinvestment Act, 697
venture capital, 583 concentration limits, 739
Insider trading in general, 619
Cuban, Mark case, 608 removal of restrictions, 697
failure to stop, 727 general, 674
front-running, 609 global, 434,
by SEC staff members, 632 U.S., 434, 694
Institutional traders, 14 Modern portfolio theory, 271
Insurance industry Money market funds
antitrust exemption, 186 background, 313
bailout funds, 188 breaking-the-buck, 313, 460
capital requirements, 184, 187, 691, 713 capital injections, 460
demutalization, 187 college funds, 561
Dodd-Frank, 762 crisis, 532
disclosure of compensation, 185 government guarantee, 533, 654, 673
federal charter, 762 growth, 314
regulation, 185–187, 762 insurance concerns, 314
subprime crisis, 187–188, 586 loss record, 314
Interest only strips, 382 state and municipal funds, 459
Interest rates subprime crisis problems, 459
cuts, 449, 451, 493, 505, 566, 589, 615 Monoline insurance
delayed effects, 707 credit ratings, 403
increases, 421, 425, 426 description, 403
policy failures, 706 losses, 403
regulatory bargain, 708 Mortgage brokers
roller coaster changes, 707 abuses, 393
targeted, 706 fee restrictions, 462
Intermarket Trading System, 1421 regulation, 396, 408
International Financial Reporting Standards yield-spread-premium, 407
(IFRS), 84 Mortgage insurance, 403
International Prisoner Transfer Program, Mortgage modifications,
17 failure of modifications, 633, 675, 686,
Interpositioning, 143 693
Inverse floaters, 381 initial efforts,446, 462, 482, 485, 518, 617,
626
Junk bonds Obama programs, 633, 647, 665
default rate, 482, 507 Mortgages
recovery rate, 618 adjustable rate mortgages, 312, 393
Alt-A mortgages, 473, 494, 585, 705
Leveraged loans appraisals
background, 258 abuses, 721
covenant lite, 260 background, 300, 484
credit crunch, 259, 443, 520 methodology, 721–722
growth, 259 consumer protection, 392
recovery, 669 conventional 304
subprime crisis, 577 covered mortgages, 513
vulture investors, 259 cram-downs, 648, 658
Liquidity crisis, 531 delinquencies, 427, 432, 466, 519, 626,
Liquidity puts, 456 634, 658, 693
Loan offices, 282 farm foreclosures, 292
Low income housing, 303 Great Depression issues, 293

Mortgages (continued) Nigerian barge case, 10, 329

guarantees, 289 NINJA loans, 393
history, 281 No-doc loans, 393
home improvement loans, 301 NYSE
insurance, 299, 303, 382 demutalization, 153
interest only, 420 Designated Order Turnaround system, 144
liar loans, 514, 705 electronic trading 152
national banks, 291 Euronext, 152
negative amortization, 420 high frequency trading, 153
payment shock, 393, 447 linkages, 150
Philadelphia plan, 287 mergers, 151–152
pick-a-pay, 394, 658 Rule 390, 142–143
piggy-back, 648 technology, 144
qualified residential mortgages, 740
refinancings, 617, 626, 656, 659 Options backdating, 107
residential foreclosures, 292, 297 spring-loaded options, 112
reverse mortgages, 313, 394, 466 Options exchanges
rollover mortgages, 312 clearing, 167
secondary market, 382 competition, 157
securitization. See Securitization cross-margining, 223
stated income, 705 exotic trades, 159
step rate mortgages, 312 Justice Department action, 158
subsidies, 304 market shares, 158
suitability requirement, 755 subprime crisis, 159
tax benefits, 304 Order protection rule, 143
teaser rates, 393, 446 Ostrich jury instruction, 58
terms, 287 Over-the-counter derivatives
underwater, 491, 492, 679 background 196
Municipal finance, 406, 570, 597 panics, 412
Mutual fund scandals regulation, 196
fair value pricing, 235 swaps. See swaps,
forward pricing rule, 233, 234
hard close, 238 Paper work crisis, 159, 168
late trading, 232 Participation loans, 302
market timing, 232 Pass-through securities, 380
net asset value computations, 233, 240 Payday lending, 467
new rules, 238 Payment for order flow, 148
outside directors, 239 Permanent loan associations, 284
sticky assets, 236 Perp walks, 5, 330
Moral hazard, 291, 499, 710 Pharmaceutical accounting, 57
Mutual recognition, 155 Pink sheets, 145
PIPE transactions, 176, 257, 608
Naked access traders, 154 Placement agents, 266
NASDAQ Poison pill, 123
linkages, 150 Ponzi schemes
SOES, 146 escapes by operators, 614
tiers, 146 homeowner insurance coverage, 613
TRACE, 149 losses, 609, 631
National Market System, 142 Madoff, Bernard, 609
National mortgage associations, 302 SIPC coverage, 610
National securities exchange, 141 Stanford, 631
NatWest Three, 15, 330 tax deductions, 610
Newspapers Portable alpha
corporate governance, 345 background, 272,
declining circulation, 346 losses, 597
influence peddling, 349 Poverty levels, 695

Predatory lending Rating agencies (continued)

background, 393, 395 government use, 647, 748–749
cases, 397 lawsuits, 754
credit insurance, 395 Reform Act of 2006, 749
Dodd-Frank, 756 regulation abroad, 657, 751
flipping, 393 triggers, 748
negative amortization, 395 RAND study, 156
preemption, 398 Real estate bonds
suitability requirement, 755 background, 288
Price quotations, 140 protective committees, 290
Private equity Real estate bubble, 421–422
annex funds, 578 Redlining, 697
background, 249 Regulatory turf wars, 730, 742
bank acquisitions, 265 Reinvestment risk, 380
carried interest, 274 Repos
corporate governance roles, 262 background, 169, 174
credit crunch, 440 problems at Bear Stearns, 496
description, 254 subprime crisis, 589
dividend recaps, 274 Retail sales declines, 468
freedom of information acts, 264 Reverse conversions, 176
golden era, 276 Reverse convertibles, 495, 663
growth, 257 Risk modeling
hedge fund ownership, 261 bank capital, 724
initial public offerings, 267, 269 Black-Scholes options model, 724
junk bond financing, 254 black swan flaw, 725
labor union attacks, 264 fat tails, 725
leveraged buyouts, 254 Gaussian Copula, 724
leveraged loans, 258 Monte Carlo simulations, 725
long term investors, 268 rating agencies, use of, 724
pension funds, 275 Value-at-risk (VaR)
performance, 275 bank capital, 178
public listings, 266 commodity margin, 226
registration as investment companies, 270 flaws, 179–180, 715
subprime crisis, 577 Long Term Capital Management, 179
Prosecutorial abuses outliers, 725
coercive tactics, 330 quants, 725
Enron cases, 7–33 testing, 724
federal prosecutors, 328 Rogue traders, 475, 664
lack of success, 679 Rumor mongering, 510
New York attorney general Russian debt crisis, 231
Cuomo, 703
effectiveness of, 704 Savings and loan associations
Spitzer, 327 demutalizations, 309, 323
other cases, 47–71 deposit growth, 308
Prudent man rule, 271 Great Depression problems, 296
Proxy votes, 117 holding companies, 308
Public Pension Fund Code of Conduct, 266 interest rate competition, 309
interest rate regulation, 307
Rating agencies mergers, 316
alternatives, 753 passbook savings, 315
bank capital role, 178 3–6–3 rule, 307
CDO downgrades, 750, Savings and Loan crisis
conflict of interest, 749 background, 307
deficiencies, 178, 748 depositor runs, 319
Dodd-Frank, 748, 753 deregulation, 317, 321
gatekeepers, 753 flipping, 318

Savings and Loan crisis (continued) Special Study of the Securities Markets, 159
fraud, 317 Squawk box case, 608
insolvencies, 315, 318 Stable value funds, 655
interest rate increases, 312, 315 Staggered board terms, 125
junk bond investments, 316 State and municipal finance
lawsuits, 321 Build America bonds, 630
liquidations, 321, 322 IOUs, 651
Keating five, 320 revenue declines, 680
net worth certificates, 316 subprime crisis, 630
Savings banks, 283 tax increases, 651
Savings rates, 422 underfunded pension plans, 651
Say-on-pay, 630 Stimulus programs
Scheme liability, 734, 741 abroad, 656
Secular bear market, 567 Bush administration, 480, 486, 504, 710
Securities Information Center, 161 Obama administration
Securitization additional requests, 680
fraud, 615 amount, 710
mortgages, 308 buy America, 630
private, 384 checks for crooks, 670
scoring, 385 contents, 630
Segregation of funds effects, 632, 670
box count, 168 European criticism, 649, 691
broker-dealers, 168 first-time homebuyer credits, 630
Customer Protection Rule, 168 passage, 629
good control location, 168 proposal, 626
Reserve Formula computation, 168 shortcomings, 679, 684
Sentencing abuses, 6 squandered funds, 695
Shareholder bill of rights, 125 shovel ready projects, 661
Short sales, mortgages, 435, 686 Stock buy-backs, 424, 426, 430, 482, 622
Short sales, stocks Stock lending, 175
abroad, 690 Stock Market Crash of 1987, 162, 193, 220,
avoiding restrictions, 531 415
Dodd-Frank, 747 Stock market
effectiveness of restrictions, 566 performance
generally, 175 after subprime crisis, 690–691
naked, 175, 511 during subprime crisis, 618, 625, 627,
PIPEs, 176 633, 652, 681
rumor mongering, 510 record in 2007, 450
temporary suspensions, 512, 531 volatility, 566, 567
tick test, 511, 594 Stock options, 104
tick test revival, 631 bullet dodging options, 112
Single family mortgage revenue bonds, 311 Stop construction order, 304
SOES bandits, 146 Street name, 162
Sovereign wealth funds Structured investment vehicles, 385, 456,
description, 276 705
investments during subprime crisis, 453, Student loans
457–458 background, 386
locations, 277 nationalization, 687
losses, 278 scandals, 388
national security concerns, 278 Subprime crisis
subprime crisis, 670 abroad, 572, 627, 648, 653, 657, 685, 690
transparency, 279 affirmative action loans
Specialists Community Reinvestment Act, 697
description, 140–141 bailout programs, 708–710
scandals, 143 bailout costs, 666–667
trading ahead, 143 bottom reached, 646

Subprime crisis (continued) Subprime crisis causes (continued)

carry trades, 707 Fannie Mae and Freddie Mac
commercial credit markets, 648 down payments reduced, 702
consumer savings rates, 628, 653 down payments subsidized, 704
corporate profits, 620, 654, 684 failure of capital requirements, 702
counseling services, 698 increased subprime lending, 705
delinquency rates of mortgages, 626, loosened credit standards, 702
653 quotas, 701–702
dividend cuts, 635 financial regulator—SEC
election issues conflicting roles, 727
during crisis, 563 financial illiteracy, 726
post-crisis, 694 Goldman Sachs case, 732
foreclosures, 653, 665 incompetency, 725, 731, 736, 745
GDP contraction, 622 revolving door, 726
government reaction staff misconduct, 734
government leadership, 710 undermining by New York attorney
liquidity programs, 708–710 generals, 726
stimulus packages, 710 functional regulation, 728
green shoots, 660 inquiry into, 696
government behavior, 710 lending practices, 697
housing prices, 628, 653 loan quotas, 563, 616
investigations, 508 real estate appraisals, 721
jobless benefits, 656, 664 Subprime lending
layoffs, 625, 628 bank lenders, 701
legacy assets, 651 Community Reinvestment Act
liquidity measures, 708–710 ACORN, 699
manufacturing, 622 community groups use of, 698
mortgage delinquencies, 621, 647 costs, 701
mortgage modifications, 626 extortion, 698
mutual funds, effect on, 694 default rates, 705
pension fund losses, 622, 651 definition, 391
productivity, 622 first crisis, 410
prosecutions, 648, 679 growth during
recovery Bush administration, 704
begins, 655, 691 Clinton administration, 699, 701
uncertainty over, 694, 695 illegal aliens, 699
regulatory reforms increases in, 705
debate over, 655, 696, 729 interest rates, 392
Dodd-Frank, 696 investigations, 483
European reforms, 655 non-bank lenders, 408
responsibility for, 616, 634, 655 percentages, 700
state and municipal finance, 630 pledges, 698
suicides, 613 quotas
TARP Bush administration, 704
government profits, 660, 672 Cisneros, Henry, 701
repayment issues, 659 Cuomo, Andrew,704
use of funds, 658 soft, 698
too big to fail issues, 710–711 securitization, 701
world trade, 622, 648, 672 subprime crisis, 621
Subprime crisis causes warehouse operations, 409–411, 449, 458,
capital requirements, 711, 713 548, 698
creative destruction, 711 Super seniors
Community Reinvestment Act, 698, capital treatment, 458
700 description, 458
compensation practices, 697 fair value accounting, 717
down payment policies, 700–702 losses, 541, 549, 751

Super seniors (continued) Twin peak regulation, 728

valuations, 717 Tyco party, 52
Suspicious Activity Reports, 75
Swaps Unbanked consumers, 467
background, 196 Unemployment rates
clearing, 744 after the crisis, 679, 689, 691
confirmations, 744 before the crisis, 434, 465
data repositories, 746 during the crisis, 474, 507, 588,
dealers, 196 622, 634, 653, 655, 657, 663,
exemption from regulation, 197 669, 675
independent research, 209 on Wall Street, 466
insider trading, 745 Union pension funds
municipal losses, 491 abuses, 275,
regulation, 743 board representation, 344
reports, 209 declining membership, 341
total return, 263 losses, 622
Systemic risk SEC assistance, 344
debate over, 655, 740 spiking, 343
Dodd-Frank, 740 subprime crisis, 588
payment systems, 173 underfunding, 342
securities settlements, 166 University endowment losses, 598, 672
Stock Market Crash of 1987, 162 Upstairs trading, 151
Target letters, 5, 9, 46 Variable forward contracts, 112, 640

TARP cop, 647, 657, 677 Venture capitalists
Taxes after the crisis, 681
cuts, 694 angels, 250
increases on foreign earnings, 676 background, 250
planning, 695 blind pools, 252
refund anticipation loans, 446 hot issues, 253
shelters, 59–65 incubator loans, 250
Telecom scandals, 37 job creation, 252
Term auction facility, 461 regulation of, 584, 747
Third market, 141 subprime crisis, 583
Thompson memorandum, 6 Viatical insurance, 643
Tiered listings, 155 Volcker rule, 731, 740
Too big to fail, 324, 418
T+3, 163 Wall Street rule, 117, 123
Trade deficit Wealth disparity, 336, 422
U.K., 628 Wealth effect, 423
U.S., 23, 693 Warehouse lending, 410
Trade through rule, 143 Wild card certificates of deposit, 315
Transfer agents, 164 Wrap accounts, 241
Trust banks, 712
Trust preferred securities, 178, 739 Yield curve inversion, 427

About the Author
Jerry W. Markham is a professor of law at Florida International University

at Miami, where he teaches corporate and international business law. He was
previously a partner in the international law firm of Rogers & Wells (now
Clifford Chance), chief counsel for the Division of Enforcement of the U.S.
Commodity Futures Trading Commission, secretary and counsel for the Chi-
cago Board Options Exchange, and attorney in the Office of General Counsel
at the U.S. Securities and Exchange Commission. Markham taught as an
adjunct professor of law at the Georgetown Law School in Washington, DC,
and was a professor of law at the University of North Carolina at Chapel Hill
before moving to Florida. He holds law degrees from Georgetown and the
University of Kentucky. Markham is the author of the three-volume series A
Financial History of the United States, published by M.E. Sharpe and selected
as a Choice Outstanding Academic Title for 2002. He also wrote a follow-on
volume to that history covering the Enron-era scandals. Markham is the author
and coauthor of several other books and articles on finance-related matters.
826

Financial History: Subprime Crisis Great Recession

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(c) 2011 M.E. Sharpe, Inc. All Rights Reserved.

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved.

Library of Congress Cataloging-in-Publication Data

Printed in the United States of America

The paper used in this publication meets the minimum requirements of

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(c) 2011 M.E. Sharpe, Inc. All Rights Reserved.

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved.

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The Fed reduced rates by a further twenty-five basis points on October

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by the government or disciplined by the market. Those concerns were muted

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threatened until the government stepped in to guarantee some $250 billion of

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comparable maturities, such as Treasury bonds. The Ginnie Mae guarantee

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Collateralized Mortgage Obligations

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Mortgage Market Growth

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balance. In contrast, borrowers insured by the Federal Housing Administra-

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of a collapse of the residential mortgage market. Critics wanted the federal

Commercial banks entered the mortgage-backed securities market. They were

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Asset-Backed Commercial Paper

The securitization concept spread to other instruments. Commercial banks

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refunded with additional long- or medium-term assets. In the event of a crisis

Securitization spread beyond commercial banks. One popular securitization

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the Chicago economist Milton Friedman noted, the prediction of a particular

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Sallie Mae’s founding legislation required it to become a private company

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No uniform standards have been established for classifying loans as subprime,

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Consumer Protection Legislation

Congress passed several consumer protection statutes related to consumer

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Predatory Lending Practices

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Nontraditional mortgages began to appear in greater numbers in the form

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which required a minimum down payment of 3 percent. The FHA sought to

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legislation was directed at particular predatory lending practices. Some states

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Fannie Mae and Freddie Mac

Fannie Mae purchased or guaranteed $270 billion in subprime loans between

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